Why Municipal Bonds Aren't A Good Investment In The Long-Run

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Michael D. Bradley holds the Chartered Financial Analyst designation and is managing partner at Bradley & Company, LLC. All opinions expressed here are his own. Bonds have had great returns over the last several years because of low interest rates, and municipal bonds (“munis” for insiders) have been no exception.

Tax-free income has always lured a tremendous demand from the wealthy. Their after-tax return can be quite high relative to corporate bonds or U.S. Treasuries, especially since Treasury yields are at historically low levels.

Generally you need to find yourself in the top federal tax bracket to have the tax benefits of municipal bonds make sense for your portfolio (ie: if your household adjusted gross income is over $370,000, it probably makes sense).

However, if there is no further legislative action to avert impending tax increases scheduled for 2013, the tax advantages of munis are likely to become even more valuable and applicable to lower brackets. And, if investors respond to higher taxes by seeking shelters, increased demand for munis might have a short term positive effect on prices.


Ever since “superstar analyst” Meredith Whitney predicted widespread muni defaults in December 2010, investors have been more concerned than ever about possible “credit risks” to munis.

Lousy growth, lower returns on pension funds, and cuts in federal aid have led to an increase in the number of local governments filing under Chapter 9 of the U.S. bankruptcy code. They included the single largest U.S. municipal bankruptcy on record –– Stockton, California, one of three municipalities in the state to file for bankruptcy in a single month. 

However, municipal bankruptcies are still exceedingly rare. From June 2011 to June 2012, only 17 municipalities or local government entities filed for bankruptcy in federal courts. Compare that to the 9,285 Chapter 11 filings by businesses during the same time. Part of this is because muncipalies generally have a lot of freedom to tax or call upon higher levels of government for assistance.

If Romney had won or the Democrats lost control of the Senate, there was a risk that the GOP could have sought to starve out cash-strapped Democratic strongholds, but it seems unlikely to happen in the wake of the election. Thus, it seems that a wave of municipal bankruptcies isn’t going to happen any time soon.

So, credit-related fears are probably unjustified for diversified municipal bond investors, but this doesn’t mean that munis aren’t still subject to interest rate risk.

Because bond prices move in the opposite direction from interest rates, when rates do begin to go up, the increase likely will affect the value of all of your bond holdings, including municipals. So, even if municipal bonds are right for you, they may not a great investment because of a future spike in interest rates.

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