You’re In The Muni
September 1 1988 by Harold Evensky
Many CEOs don’t understand the relationship between inflation, interest rates and bond performance. As with any investment with a fixed rate of return, inflation is a risk with bonds. The rule of thumb is that the higher the inflation rate, the higher interest rates will rise-and the less your interest payments will be worth. As interest rates rise, the value of bonds shrinks accordingly.
What’s important to remember, however, are the reasons for taking a bond position in the first place: if there are other investments in your overall portfolio that protect you from inflation, and the long-term strategy continues to make sense for your situation, then another rule of thumb applies: long-term safety comes from diversification.
I recently restructured the bond portfolio of the CEO and owner of a successful packaging firm. He was invested in a high-yield municipal bond fund whose manager had an aggressive management style. (He bought the fund some two years before because of its high yields.) This client was 60 years old, near retirement, and the bonds represented almost half of his retirement savings. I asked him how comfortable he was being so heavily invested in a low quality bond fund. His response was, “What do you mean, low quality?” He didn’t understand that municipal bond funds with high yields usually carry lower ratings (i.e., the underwriting government is considered less strong financially than higher rated bonds’ municipalities; therefore the risk is greater). That is why the bonds pay a higher yield: to attract investors despite the greater risks. In this case, the investment was inappropriate. It was a risk the client did not understand, and in light of his imminent retirement, did not need to take.
In restructuring his portfolio, we brought in a large percentage of high-quality, highly rated funds, such as Midwest Tax-Free Limited Term and Calvert Tax-Free Limited Term, and reduced the average maturity from more than 20 years to about five years. This cut his yield by about 25 percent, and also considerably lowered his risk that the price would fluctuate, which, for this client, was more important than the presumed loss of income.
Investing in municipal bonds or munis, as they are often called, isn’t simple. As recently as 10 years ago, I wouldn’t have made that statement. Then there wasn’t much difference in the types of bonds on the market, and the number of new issues each year was relatively modest.
Today, the municipal bond market is a new ball game. Now, an investor can choose from more than 20,000 issues that represent more than $1 trillion in outstanding bonds. With recent tax reform and a Supreme Court ruling that brings into question the perceived constitutional protection of the tax-free status of munis, today there exists a great deal of confusion about whether municipal bonds are appropriate investments.
With the Tax Reform Act of 1986 came new, lower tax brackets that took away many of the incentives of tax-favored investments-of which municipal bonds are one type. Not too long after the act was signed into law, I had several queries from clients as to whether or not they should stay in their muni-bond funds.
The senior executive of an international chemical company was advised by his accountants not to buy municipals anymore because they were no longer a good investment. Their rationale was: an 8 percent muni would yield a 16 percent tax equivalent under the old 50 percent tax bracket, and only 11.9 percent in the new top bracket of 33 percent. This advice fails to recognize that investment planning is based not on how much you pay in taxes, but on how much you keep after taxes. Using this approach, you can determine if buying munis still makes sense in today’s tax environment by doing a little math. To compare today’s taxable yields to tax-free yields is a simple calculation based on what is called the “complement” of your tax bracket (i.e., Tax Equivalent Yield equals one, divided by one, minus the Marginal Tax Bracket, multiplied by yield). Today, most highly compensated CEOs fall in the 28 to 33 percent tax bracket. Using 30 percent as an average, the complement is 0.7 (the inverse is 1.43-1 divided by Simply by dividing a municipal bond yield by 0.7 or multiplying by 1.43, you arrive at the tax-equivalent yield. For example, if a quality, 10-year tax-free bond yields 7.5 percent, you would need to purchase a similar taxable bond yielding 10.7 percent (7.5 percent multiplied by 1.43) to match the after-tax return. In today’s economic environment, municipals will out-yield-on a tax-equivalent basis-taxable bonds for the 28 percent and 33 percent tax-bracket investors. So, for most top-earning CEOs, municipal bonds remain a viable investment alternative.
In addition to traditional, no-questions-asked, tax-free bonds, there are now “sort of tax-free” and “totally taxable” municipals. These “sort of tax-free” bonds are more appropriately referred to as Alternative Minimum Tax (AMT) Municipals.
The income from an AMT muni, while free from regular federal income tax, is included in the calculation of the new, personal alternative minimum tax. Because of the market’s current confusion over these quasi-tax-frees, the yields on AMT bonds are higher than comparable, totally tax-free municipals. If you aren’t subject to the AMT, these types of munis could represent an opportunity for you.
It seems that discussions on investing in municipal bonds always begin with talk of I their tax advantages; the tail wagging the dog. Any investment decision should be made based on the goals of your overall financial plan. You then make investments that work in concert with your strategies and other investments in obtaining these financial goals.
With our clients, once it has been determined that muncipal bonds are an appropriate part of their portfolio; we design the appropriate mix of bonds -a portfolio within a portfolio, if you will. First, we look at the current muni-bond yield curve. By analyzing the additional yield available for longer maturities, against the higher interest rate and call risk, we can determine the optimum maturity range; in today’s environment, a maximum maturity of 10 to 12 years.
Next, we determine the distribution of maturities within this range. This is primarily a function of an individual’s current income needs. A higher cash flow requirement would lead to a greater concentration in the longer maturities. If cash flow isn’t a critical issue, we recommend a staggered maturity, or what I call a “stepladder” (see Figure I). If rates were to drop precipitously, a similar analysis would show an average maturity of six years and an average yield of 71.1 percent. Thus, with an 80 percent swing in market rates, the intermediate term, staggered portfolio yield would vary by only 26 percent. Figure one also shows the results of the portfolio if rates were to increase by 20 percent over the next two years.
Once the proper mix of maturity and maturity distribution is determined, we look at the quality of bonds you’ll want to buy. The focus here should be diversification, not ratings. It should include diversification by state, unless you are in one with a relatively high tax as opposed to a nuisance tax such as in the state of Florida. We would also diversify bonds by type and sector. In addition, we would recommend considering a minimum of eight to ten issues. When these criteria are met, I recommend 60 percent A rated, 25 percent AA and AAA and, if the extra yield for lower quality is significant, 15 percent BBB bonds; otherwise, 75 percent A bonds.
This is my approach for constructing a muni-bond portfolio. If it were appropriate for an investor, we’d also look at premium and AMT municipals; for example, Tarrant County, Texas, a 9.2 percent bond originally scheduled to mature in September 1997. It will be called in September 1995 at a premium of 2 percent. This is a pre-refunded AAA/Aaa bond yielding 6.75 percent to the call. And, since the strategy assumes that the bonds will be held to maturity, odd lots or amounts not divisible by $25,000 can offer additional yields.
Over the years, I’ve found that munis very often are good investment alternatives for CEOs. However, every client’s situation is different and there’s no way to determine if you’re a candidate for munibond investing, other than crunching the numbers. If I had to give a rule of thumb here, acknowledging that rules of thumb are subject to a multitude of exceptions, I’d put it this way: If you were subject to the maximum tax rate before tax reform or TRA ’86, you probably are today. And if that’s true, then municipal bonds may represent a good investment opportunity for you.
UNDERSTANDING MUNICIPAL BONDS
To understand how the market for municipal bonds works, it is necessary to look at three fundamental concepts that control how these investments are valued: ratings, insurance and yield.
Ratings. There are two major rating services for munis: Moody’s and Standard & Poor’s. Moody’s is frequently perceived as the more conservative, because it focuses its analysis on the issuing city’s debt burden and budgeting; that is, it takes a historical viewpoint. Standard and Poor’s, on the other hand, places more emphasis on current and projected economic, environmental and socioeconomic issues. Neither has a perfect track record, so beware of placing too much emphasis on ratings.
Insurance. The growing popularity of insurance of muni bonds is based on the concept known as the “plywood effect.” Namely, by layering one guarantee upon another, the safety is increased geometrically. For example, if a bond has a 3 percent chance of default and its performance is guaranteed by an independent insurance company that has a 2 percent chance of default, the ultimate risk of loss drops to .06 percent. Although I’m frequently asked by clients if a bond is insured, I’ve never been asked, “Who is the insurer?” Since most insurers are consortiums, few investors are in position to know what the consortium members’ obligations are, or what portion of their resources are committed to the guarantees. The bottom line is not to assume your bond is safer because it is insured.
Yields. It is difficult to understand how munis work without a basic understanding of the relationship between time, yields and total return. This relationship is known as interest rate sensitivity or the interest rate risk. Stated simply, bond values fluctuate inversely with movement in interest rates. Major determinants of the volatility of this fluctuation are the bond’s coupon, yield (original), and maturity. Generally, the lower the coupon yield and the longer the maturity, the greater the volatility.
A fundamental measure of the existing market yield versus maturity is a graphic representation of yields for a set quality of bond over a full range of maturities. This graph is known as the yield curve and is a major tool used in determining the maturity range to be used in a bond portfolio design.
A majority of investors are confused as to exactly what yield is, because there are a number of different measures of yields. The simplest, the coupon yield mentioned earlier, is the interest-rate percentage committed to by the issuer at the time the bond was issued. Thus, when referring to a “5 percent bond,” the 5 percent is the coupon yield. Unfortunately, since bond prices fluctuate with interest rates, a purchaser of an existing bond in the secondary market might pay more, a “premium,” or less, a “discount,” relative to the bond’s original issue price or par value. As a result, the new owner’s actual yearly return or current yield may be more or less than the coupon yield.
To compound the confusion, the current yield does not account for the loss of the premium at the maturity, or “call,” if a premium bond, or the capital gain at maturity of a discount bond. This measure for discount bonds requires a new yield computation known as “yield-to-maturity,” and for premium bonds, the “yield-to-call.” These yield measures reflect total returns and should be used when comparing competitive issues. One caveat: yield-to-maturity on discount municipals must be adjusted downward to reflect the tax on the capital gain at maturity.
Harold Evensky is a managing partner of Evensky & Brown, a Coral Gables, Fla.-based personal financial planning firm.