Municipal Bonds: While Others Bail, It Might Be a Good Time to Buy

Investors have been bailing out of beleaguered municipal bonds in droves, worried that higher interest rates will drive down the prices of the bonds.

About two weeks ago, weekly net outflows from muni bond mutual funds and ETFs soared to a record $4.53 billion, Lipper data shows.

And in five of six weeks ending in early July, withdrawals hit a four-week moving average of $2.21 billion.

So it's time to join the crowd and dump your munis, right?

Not so fast.

In fact, it could be a good time to buy well-chosen munis to boost your income investments.

"I am against conventional wisdom on munis at the moment," says Money Morning Chief Investment Strategist Keith Fitz-Gerald. "They have been beaten down so far that the income is extremely appealing ... assuming investors manage the risks appropriately."

Muni Bond Funds Now Below Net Asset Value

"If you're using munis as an intelligent part of a portfolio and looking for the income they provide, many munis have been beaten down to the point that they're way under their net asset value," Fitz-Gerald says.

The outflows from muni bond funds came amid expectations the Federal Reserve will begin scaling back its $85-billion-a-month bond-buying program.

That, in turn, could lead to an increase in interest rates and a corresponding decline in the price of munis, investors fear.

But if munis have bottomed out, there's no way for the prices to go but up, whatever the Fed does.

"The buffet is full and you can be pretty aggressive with dealers on price," Michelle Knight, chief economist at Boston-based Silver Bridge Advisors, told Reuters.

Fitz-Gerald said the Fed will continue its easy-money policies for now.

"As for muni prices, that means they will stay stable and even improve despite the fact that people think they're dead and buried," Fitz-Gerald said.

Threat to Muni Tax Breaks

Munis have been popular with retail investors, particularly wealthy ones, in part because of the federal tax exemption on the interest from the bonds.

But the exemption could be limited under a proposal from the Obama administration.

Under the proposal, part of a tax measure before Congress, the tax exemption on muni interest would be capped at 28% for taxpayers in the top bracket.

Thus, in an example cited by Forbes magazine, if someone in the top (39.6%) tax bracket earned $10,000 in municipal bond interest, the tax bill, now zero, would climb to $1,160 in federal income tax. That's based on 39.6% of $10,000, or $3,960, minus the exempt amount, 28% of $10,000, or $2,800.

The muni tax proposal has drawn stiff opposition from state and local governments, which say it would increase the cost of projects financed by the bonds, including schools, hospitals, roads, transit, water and other critical infrastructure.

Forbes contributor Kelly Phillips Erb notes there's a good reason for the tax exemptions (some munis are also exempt from state taxes): The government has an interest in encouraging private investment in vital public projects.

If the tax exemption is limited, Erb notes, it will prompt some muni investors to look to other places to invest their money.

"A higher tax bill on municipal bonds means that affected investors - those that can afford to shop around - will necessarily seek out other options," Erb wrote. "They'll look to find investments that pay out at a higher rate to make up for the higher bite. The result?

"Instead of money going to public projects - repairing bridges, fixing dams, funding schools - it will go to Apple. Or Netflix. Or Coca-Cola. Or Citi," she points out. "Is that what we want? There are already plenty of incentives to invest in the private sector; we shouldn't erase incentives to encourage private investment in the public sector."

So keep your eye on Washington and this proposal.

For now, though, well-chosen munis remain a solid investment bet.

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