Chasing Muni Yields Carries Risks

These days, Cummings may find it easier to grab listeners' attention. Over the past two months, municipal bond yields have consistently exceeded Treasury yields, even before factoring in the tax advantage. As of May 7, 30-year Treasurys yielded 4.61%, while AAA-rated (the highest credit quality) municipal bonds of the same maturity hit an average 4.88%. Since interest earned on munis is tax free, that's the equivalent of a taxable investment yielding 7.3% for someone in the 33% tax bracket, or 6.5% for someone taxed at 25%. Shorter-maturity Treasurys were also close, or lower than AAA-rated munis on a pretax basis, while munis rated AA or lower exceeded Treasury yields on all fronts. "I've been in institutional trading and sales of municipal bonds since the late 1980s and I've never seen such a run," says Cummings. "Never all through the curve and never for so long."

Normally, municipal bonds yield less than Treasurys, with the tax-free interest making up the difference for investors in the highest tax brackets. But the credit crunch and concerns with bond insurers' downgrades caused many institutional investors to sell off munis and other securities not guaranteed by the government. "There was a flight to quality in the past 12 to 15 months where investors sold anything with risk and bought Treasurys," explains Scott Berry, senior fund analyst with research firm Morningstar. The selloff suppressed muni prices and, consequently, pushed yields up. Increased demand had the opposite effect on Treasurys.

As a result, investors as low as the 25% tax bracket may be compelled to shift a part of their fixed-income portfolios to municipal bonds. And given the paltry returns of money-market funds and savings accounts these days, munis may even sound like a good place to park your extra cash.

For most investors, however, the risks outweigh the returns. "Right now the yields look fantastic and juicy, but they're juicy for a reason," says Michael Boone, a fee-only certified financial planner in Bellevue, Wash.

If a municipality relies largely on collecting real estate taxes, for example, falling property values would cut into revenues — a problem that many municipalities have not had to deal with in recent history. Just this week, the Northern California city of Vallejo declared Chapter 9 bankruptcy, allowing it to continue providing services while freezing its debts. When a municipality declares bankruptcy, the bond insurer would typically take over payments of principal and interest, Boone explains. But should the number of such bankruptcies increase, investors now question the ability of insurers to take over the financial burden.

Hence, the importance of location, Boone warns. "A real estate-led decline, unlike other struggles in the economy, is very much localized. When we build a portfolio for clients, we consider geographic diversification just as important as maturity diversification and credit diversification."

For a combination of high yields and safety, Cummings recommends pre-refunded or escrowed-to-maturity bonds. These are bonds that municipalities have refinanced into Treasurys at some point in the past to take advantage of lower interest rates. Since they continue making the original coupon payment, investors get higher yields for a security backed by the government.