Ben Margot/AP/File
The historic Hotel Stockton stands forlorn. A year ago, Stockton, Calif., became the largest city in America to declare bankruptcy, sending a shiver through the municipal bond market.

New caution over municipal bonds

Municipal bonds have provided strong returns with tax-free interest. But now those 'safe' investments look risky as downside risks accumulate for municipal bonds.

Municipal bonds have almost always been a go-to place for those who like to sleep soundly at night.

They're considered safe. And their interest is tax-free, which is increasingly important to high-income individuals whose federal taxes are moving higher.

When financial adviser Bob Williams recently shopped for bonds for an Arkansas client, he found 13-year issues from the Little Rock School District yielding 2.87 percent for at least the next three years. (The district can redeem the bonds at that point.) That's no huge yield. But after taxes, it beats what the client would have gotten from a comparable corporate bond, points out Mr. Williams, a senior vice president at Delta Trust Investments in Little Rock.

So why are some financial advisers now cautious about municipal bonds? The returns have been so good and the yields have slid so low that they believe the market has little room for more gains. And other concerns – an interest rate rise, a possible cap on munis' tax benefits, and bigger trouble for Puerto Rico's bonds – loom on the horizon.

With "yields close to generational lows, new investors have to be beyond cautious," warns Marilyn Cohen, chief executive of Envision Capital Management, a Los Angeles-based manager of fixed-income portfolios. "There is no juice left in that market."

That outlook is a sharp turnaround from the past two years. In 2011, the muni market enjoyed a total return of 10.7 percent, according to the Barclays Municipal Bond Index, rallying from a scare in late 2010 caused by an analyst who forecast widespread muni bond defaults, which never materialized. In 2012, munis gained 6.8 percent.

A limited supply of muni issuances is one factor buoying the market, but so far, its total return has been only a little more than 1 percent. "The market would be lucky to get a 3 percent to 3-1/2 percent total return" this year, Ms. Cohen says.

Muni investors' main concern is that the US Federal Reserve will begin to hike interest rates. (Bond prices fall when interest rates rise.) Even if the Fed doesn't act soon, other worries loom.

The biggest: the possibility that Congress would cap the amount of muni bond interest that would be tax-free, says Matt Fabian, a managing director at Municipal Market Advisors, a research firm based in Concord, Mass. As part of the Obama administration's current budget proposal, interest on muni bonds would remain free of federal income taxes only for those in the 28 percent tax bracket or below. The tax rate for wealthier investors would be the difference between their regular tax rate and 28 percent.

Puerto Rico is another of the market's worries. The island's bonds are free of federal, state, and local taxes throughout the United States, but the government is heavily indebted, and the island's economy has been weak. Between December and March, the three major US credit rating agencies downgraded the island's general obligation bonds to one notch above junk-bond status, with negative outlooks. Many muni bond funds hold Puerto Rican bonds because they're offering more attractive returns than those of other juris­dictions. If the bonds do fall into junk status, at least some funds would be forced by their own rules to sell them, driving down the values of many investors' portfolios.

Stockton, Calif., symbolizes another market worry: bond defaults. Last year Stockton became the largest American city to declare bankruptcy. The city has defaulted on a substantial amount of bonds, causing bond investors and bond insurers to worry about when they'll get repaid and prompting fears that other financially troubled cities could follow suit.

But it's possible these scenarios won't occur.

"There are no indications from current economic data that interest rates will be rising anytime soon," says Alexandra Lebenthal, president and CEO of Lebenthal & Co. in New York City. The muni "market is still a buy," she says, and "people are still looking for tax-exempt income."

Government revenues "are improving," says Patrick Early, chief municipal analyst and a managing director at Wells Fargo Advisors in St. Louis. And any problem areas can be avoided.

"Investors should stick to the bonds used for essential services, like those used for water and sewer projects, or to general obligation bonds, backed by taxes that can be raised if necessary," he says. "These kinds of bonds represent the best quality with the lowest risk profile and can perform well in good and bad economic times."

Another strategy: Avoid long-term commitments to muni bonds. "Anyone looking at the municipal bond market now needs to look for shorter maturities and do homework on the issues," says Delta Trust's Williams.

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