Posted on: Sunday, August 10, 2003

Municipal bonds good outlet for savers

By John Waggoner
USA Today

Savers are getting returns smaller than an army ant's canteen. If you're looking for more yield, and tax savings, consider adding some municipal bonds. But because this is a treacherous time for all bond investments, start small if you're going to invest now.

The Federal Reserve Board has pushed down short-term interest rates 13 times to get the economy moving. Recently, investors got some indications that the Fed's policy is working: The Commerce Department reported that the economy grew at a 2.4 percent annual pace during the second quarter.

The Fed's actions have pummeled savers on two fronts. Short-term savings rates have moved from minuscule to pathetic. The average money market mutual fund, for example, yields just 0.53 percent, or $5,300 annually on a $1 million investment.

Investors have poured $68 billion into bond funds this year, trying to get higher yields. Those who did got their second pummeling. The average government securities fund, a popular type of bond fund, has fallen 2.3 percent the past four weeks, including reinvested interest.

What happened?

Unfortunately for these investors, the Fed doesn't control long-term interest rates. The bond market does. Even more unfortunately, the bond market was temporarily insane earlier this year, driving long-term rates to ridiculously low levels.

When rates rose this month, bond investors got hurt. Why? Bonds are long-term IOUs issued by corporations, the U.S. government, states and municipal organizations, such as cities and towns. They pay a fixed interest rate until they mature, when the issuer returns your principal.

Bond traders can't change the interest payment on a bond. So they bid bond prices up or down to change a bond's yield — its interest payment divided by its current price. Consider a $1,000 bond that pays $50 a year. It has a 5 percent yield. Push the price up to $1,100, and the yield falls to 4.5 percent. Cut its price to $900, and the yield rises to 5.6 percent.

Earlier in the year, traders pushed yields down and prices up because they thought the country could go into a period of falling prices, or deflation, which would boost the value of a bond's interest payments. And rumors swirled that the Fed would buy massive amounts of Treasury bonds, pushing rates down even more.

Joe Deane, star municipal bond-fund manager at Smith Barney, thinks traders went too far.

"It was just crazy," he says. When it became apparent that the U.S. economy wouldn't sink into depression, bond prices started to fall, and yields started to rise.

Why invest in muni bonds now? First, munis are offering attractive yields, at least compared with Treasuries. A five-year T-note yields 3.2 percent, vs. 2.8 percent for a high-rated five-year municipal bond. That doesn't seem particularly attractive, until you consider that muni bond interest is free from federal income taxes. If you live in the state where the bond was issued, interest is free from state taxes, too.

Those tax savings boost a muni's effective yield. Think of it this way: If you're in the 31 percent tax bracket, you have to earn 4.0 percent to get 2.8 percent after taxes.

And munis are probably safer than corporate bonds. Muni yields have been high because of worries about state budget deficits. But state defaults are extremely rare: A state can raise taxes to pay its debts. The last state bond default was in 1838, when Mississippi defaulted on its bonds.

Just 18 muni bonds have defaulted since 1970, and 10 of them were issued by hospitals, says Moody's Investor Services.

An improving economy will make bonds that investors now treat as radioactive seem more appealing. A 10-year California bond, for example, yields about 4.75 percent.

Will California default?

"I'd bet a lot of dollars that won't happen," says Lyle Fitterer, muni bond manager at the Strong funds.

And despite stronger economic growth, inflation, which eats away the value of a bond's interest payments, still seems unlikely. The economy just isn't growing fast enough to spark rising prices.

Mark McCray, municipal bond manager at Pimco, says earning 4 percent to 6 percent after taxes on munis is not only possible now, but a good deal.

And in these days of ant-sized yields, he's probably right.