Muni Bond Basics for Investors: Know the Benefits & Risks

Originally published: March 26, 2020

Municipal bonds, aka munis, may not come to investors’ minds every day. But muni bonds are at work all around us, providing funds to build roads, bridges, parks, schools, and other things vital to our everyday lives that may yet be taken for granted. Two-thirds of infrastructure projects in the United States are funded by muni bonds, according to the Municipal Securities Rulemaking Board.

Tax-free muni bonds may be appealing for many investors, and muni bonds in general can be a valuable tool for a long-term portfolio strategy, according to Roza Shamailov, senior manager, fixed income trading and syndicate at TD Ameritrade. Investors should also be aware of a few caveats and potential downsides of muni bonds. Let’s look at a few muni bond pointers for investors.

What is a Muni Bond?

Muni bonds are interest-bearing debt obligations sold by a state, county, city, or other government agency or authority to finance public capital projects. In addition to schools, roads, and bridges, these projects may include hospitals, jails, stadiums, and low-income housing.

Similar to Treasuries and other types of bonds, munis are considered debt securities. They’re tradable financial instruments with predefined principal amounts, interest, and maturities. Munis are also considered fixed-income securities, meaning investors receive periodic interest payments (typically every six months) of a nonvariable amount until the bond matures. There are two main types of municipal bonds: general obligation bonds and revenue bonds. A general obligation bond is paid back through the unlimited taxing power of a state or local government. A revenue bond is paid back through the project’s ability to raise revenue and pay off debt, which typically makes this type of muni higher risk than a general obligation bond.

There’s also a third type of muni called a private activity bond. It’s sold on behalf of a municipality but for the benefit of a private entity such as a sports team. Each bond offering comes with its own set of riders, clauses, and potentially unique risks, which are all spelled out in the prospectus.

How Big is the Muni Bond Market?

In dollar terms, the muni bond market is a relative pipsqueak compared to its Treasury and corporate counterparts, but muni numbers are nothing to sneeze at. In 2018, the U.S. muni bond market had a total value of $3.8 trillion and about $11.6 billion worth of munis were traded each day, according to the Municipal Securities Rulemaking Board.

By comparison, the corporate debt market totaled $9.2 trillion in 2018 and about $31.2 billion in corporate bonds traded each day.

What Do Muni Bonds Yield, and How Has the Market Performed?

Muni bond rates vary depending on the creditworthiness of the entity selling the bonds. The most creditworthy muni bond issuers—those with the lowest risk of default—pay lower rates than the less creditworthy, which carry a greater risk of default. An AAA-rated muni bond—the highest possible rating—pays a lower rate than an A-rated muni.

As of late December 2019, U.S. yields for 5-year and 10-year muni bonds averaged about 1.15% and 1.5%, respectively, according to Bloomberg data. By comparison, 5-year and 10-year Treasuries yielded 1.73% and 1.92%, respectively.

As for returns, muni bonds in recent years had a solid, if unspectacular, performance in the broader market scheme of things. The S&P Municipal Bond Index, which reflects the performance of more than 200,000 bonds, had posted a return of about 7.2% for the year through late December 2019. The S&P 500 Index, which represents the U.S. stock market, was up 28% for the year.

Over the long term, muni bond returns also lagged the S&P 500 and did only a little better than the rate of inflation. The S&P Municipal Bond Index posted an average annualized five-year return of 3.6% and an average 10-year return of 4.4%. (Yields and other information on specific muni bonds can be found by using the TD Ameritrade Bond Wizard).By comparison, the corporate debt market totaled $9.2 trillion in 2018 and about $31.2 billion in corporate bonds traded each day.

What Are the Tax Benefits of Muni Bonds and Other Tax Implications of Muni Bonds?

Interest earned on corporate or Treasury bonds is taxable, but that’s not the case for most muni bonds. For investors, “the main advantage of investing in municipal bonds is earning tax-free interest,” Shamailov said.

When comparing municipal bonds to other investments, she suggested investors consider “taxable equivalent yield,” also called the after-tax yield.

The after-tax yield accounts for tax consequences incurred by either a capital gain or ordinary income, and because the interest on most municipal bonds is excluded from federal income taxes, the tax savings to the investor vary depending on an investor’s tax bracket and the yield on the bond.

For example, an investor in the 35% federal tax bracket considering a muni bond with a 3% yield would have to earn 4.61% on a taxable investment to equate to the 3% tax-free investment.

In this example, the taxable equivalent yield “is being factored using only the federal income tax exemptions,” Shamailov said. “State and local exemption would push the taxable equivalent yields on municipals higher, which would improve the appeal to investors in lower tax brackets.”

In other words, muni bonds aren’t free lunch. Investors should understand the potential tax implications before they dive into the muni market.

What Are the Risks of Investing in Muni Bonds?

The primary risk in muni bonds is an issuer default—for example if a city or other government body goes bankrupt or otherwise can’t pay its debts. That’s a relatively rare occurrence in the muni bond market.

In 2018, the default rate for investment-grade municipal bonds was 0.18% compared to 1.74% for investment-grade corporate bonds, according to the Municipal Securities Rulemaking Board.

Other risks include opportunity cost, meaning muni returns could be lower than what you might have received if you invested in something with a higher risk/return factor. And, although certain muni bonds are exempt from federal, state, and local taxes, interest income may still be subject to the alternative minimum tax (AMT).

Muni interest income could also negatively affect Social Security benefits because the IRS considers those payments as income when calculating taxes on Social Security benefits.

Are Muni Bonds More Appropriate for Some Types of Investors?

“Historically, tax-exempt muni bonds have been favored by investors in higher tax brackets,” Shamailov said. “But investors in lower tax brackets can also reap the benefits of munis.”

Again, the interest earned on munis is exempt from federal income tax and, in many cases, is also exempt from state and local taxes for investors residing in the state where the bond was purchased. Tax-free munis may also appeal to investors in retirement or approaching retirement.

Seasons of Advice Wealth Management, Stewardship Personal Values PortfoliosSM

Originally published: March 25, 2020

QUESTIONQuestions by:
The Socially Inspired Investor Digest

ANSWERInterview with:
Charles Hamowy, CFP®, CPA/PFS – CEO Saad Tahir – SVP & Partner – Investments & Operations Seasons of Advice Wealth Management, LLC.

QUESTIONWhat inspired you to start the Stewardship Personal Values Portfolios? Or rather, what event or series of events lead to the creation of these portfolios?

ANSWERCH: In February a couple of years ago, I think we will all remember a horrific shooting at the Marjory Stoneman school in Parkland Florida. Now certainly there had been other terrible mass shootings but for some reason it seemed we had reached a tipping point. Almost immediately I started to receive calls. All from clients with whom we have worked on behalf for decades. But now asking a question they’ve never asked before, am I investing in gun companies. The truth is pretty much all mainstream index funds do include gun companies. It dawned on me that for whatever reason the time had come that we need to be more accountable to not just returns, which are extremely critical but also the values that people have. And it’s not only guns. People have strong feelings about the environment and even the way companies treat their employees. We knew it would be hard but partnering with companies like Morningstar and others, we were able to build an investment strategy that not only focused on risk balanced returns, but also gave our clients a way to vote their investment dollars to reflect their personal values. This became the Stewardship way of investing. For the future we believe this kind of filtering will result in better performance in the long run.

QUESTIONDescribe your approach on how you filter investments for the Stewardship Personal Values Portfolios?

ANSWERST: At Seasons of Advice, we use a proprietary scoring algorithm to filter mutual funds and ETFs through the Morningstar DIRECT platform. Using their data and additional screening through Sustainalytics, we are able to filter this list of investments further by eliminating all investments that are rated average or lower on the Sustainability Rating spectrum. This filters the list of investments down from a few thousand options, to a few hundred. We then overlay this list of investments with an additional layer of filters revolving around specific areas of concern that include controversial weapons, palm oil, thermal coal, tobacco, small arms, and animal testing, which is optional. We look to eliminate investments that have more than 5% of their assets invested in companies involved in any of these areas of concern. Once filtered for the areas of concern, we look for the best option in each of the asset class categories that are represented in our firm-wide allocation models. We compare the investment in each category to its relevant benchmark to make sure the performance is in line or better and then add the investment to our “buy” list. This filtered list of mutual funds and ETFs is also complemented with some individual stocks that score high on ESG concerns to add a little extra alpha to the portfolio.

QUESTIONWhy is this approach different than buying a singular socially conscious fund like the Vanguard FTSE Social Index Fund?

ANSWERST: That’s a great question! What singular investments like the FTSE Social Index Fund are offering you is one investment that primarily invests in stocks and comes with the risk metrics of a stock investment. Our goal with the Stewardship Personal Values Portfolios is to provide a fully asset-allocated portfolio that not only manages risk by giving you access to stocks, bonds and alternatives but further breaks out those categories. I believe this focus on a fully asset-allocated portfolio and risk management by investing in multiple asset classes is the single biggest differentiator between a pre-packaged fund like the FTSE Social Index Fund and our Stewardship Personal Values Portfolios.

QUESTIONHave you been surprised by any of the findings once you started filtering for these specific “areas of concern”?

ANSWERST: There’s been a few surprises or “aha” moments as we have continued to work on the Stewardship Personal Values Portfolios over the past couple of years. The biggest one that comes to mind is the continuous addition of investments that now have an ESG mandate. This can be seen in recent announcements by people like Larry Fink, the CEO of BlackRock, who wants to turn BlackRock into an ESG focused asset manager. Another big surprise to me personally was how performance wasn’t affected by focusing more on investments that have an ESG focus versus investments that did not. In the past, one of the biggest reasons for not investing in these ESG investments was the belief that they tend to underperform their non-ESG focused counterparts. When we began to filter investments for our Stewardship Personal Values Portfolios, we came across countless options in multiple asset classes that were either outperforming or performing in line with their non-ESG counterparts and the subsequent indices. I think as this space continues to evolve over the next few years, we’ll find ourselves being surprised less and less since ESG focused investments and investing seems to be the way the industry is headed.

QUESTIONHow does weaving personal value choices or principles into an investment portfolio strategy help or hurt performance?

ANSWERST: Based on the results we’re seeing; performance is definitely not being hurt by investing ones personal value choices or principles as part of the investment strategy. We have a number of clients who have now been invested in the Stewardship Personal Values Portfolios since the onset in late 2018 and the performance since inception is on par, if not out-performing their blended benchmarks. As we mentioned before, we continue to back-test these portfolios using Morningstar DIRECT portfolio snapshots over the last 1, 3 and 5 years. The trend appears to be that these portfolios will perform just as well if not out-perform their blended category indices. Again, this is a back-test based on data already available and no guarantee for future results but the fact that more and more investments are now being offered with an ESG mandate will only help portfolios outpace their blended benchmarks.

QUESTIONThe risks to investors of most Climate Change scenarios seem overwhelming for the next decade. How do Stewardship Personal Values Portfolios manage climate risk?

ANSWERCH: As Saad mentioned, the Stewardship portfolios only feature companies that have above average or high ratings for Environment, Social and Governance. The investors pool their money to try to influence the decision makers. By proactively filtering out activities companies that are unfriendly to the environment like thermal coal and palm oil producers, our investors are giving a clear message that they will not allow their money to fund these types of companies. Even more so, Stewardship Portfolio investors along with all the other ESG oriented investors expect the Leaders of these companies to take the efforts to respect the environment with the hopes that one day, working together, we can have an impact on climate change.

QUESTIONHow do Stewardship Personal Values Portfolios determine which responsibly managed companies are well-positioned to provide strong long-term growth?

ANSWERCH: That’s an interesting question. Well really, the Stewardship fund follows the same process the parent company uses to determine the best investments for the future. The highly successful Seasons of Advice methodology and algorithms that have been used in the mainstream investments for decades are part of the approach for the Stewardship portfolios. The goal of all the company investments is to meet or exceed benchmarks net of fees. We are very proud of our results.

QUESTIONHow do you think the Stewardship Personal Values Portfolios will evolve over time since the industry seems to be moving in the direction of “green/ethical investing”?

ANSWERCH: We are already working on Stewardship 2.0. We now have the technology for consumers to custom build a portfolio by selecting from a long list of what are called impact items. Specifically molding the investments to further customize target goals such as focusing on women’s and diversity issues as well more focused client issues.

The Sustainable Finance Podcast: Sustainable Finance Knowledge for Financial Advisors

I launched The Sustainable Finance Podcast (SFP) in May of 2018 based on the same choices I made as a mid-career financial advisor that doubled my practice revenue over five years by integrating sustainable and ESG investment strategies into client portfolios. Those choices also motivated me to write 49 sustainable finance leadership articles for FA Magazine over a four-year period, beginning in 2014 after I sold my practice.

My favorite podcast programs are conversations that reveal the personal passion of the subject matter expert guest for any one or more of the UN SDGs. I figure that since 191 UN member countries agreed in 2015 on the most important global issues facing humanity, we should keep the conversation alive and well. And my One for All Pledge is: Clean Water and Sanitation – SDG #6.

In 2018 I saw the SFP digital media platform as my next best opportunity to promote this once-in-a-generation business building opportunity for motivated RIAs and advisory practices. The timing was also perfect to support Paul Ellis Consulting’s co-sponsorship of the 2018 Sustainable Investing Conference at the United Nations, which focused on introducing the UN Sustainable Development Goals (SDGs) to members of the U.S. Registered Investment Advisor (RIA) industry.

We recently posted Episode 70 and the Sustainable Finance Podcast (SFP) subscriber base is over 5,000 across several distribution networks. I’m now seizing opportunities to write about SFP conversation topics for investment industry publications, joining and moderating ESG conference panels and having podcast conversations with senior UN officials and corporate CEOs. Public and private sector thought leaders are eager to tell their business critical and public policy ESG integration stories to the SFP investor and advisor audience.

I’m proud to say that 51% of SFP thought leader conversations are with women advisors, portfolio managers and sustainable finance analysts. And I believe that the gender composition of the financial services industry is gradually shifting in favor of women advisors to women clients as the largest intergenerational wealth transfer in history gains momentum over the next decade.

The other major financial services industry trend I see rapidly growing and eventually becoming dominate is digital communications, marketing and service delivery. Financial advisors and asset managers in Europe will be paying a government regulated price for their carbon footprint by year-end 2020. And I expect that the same will be true in the U.S. and Asia before too long, as the Baby Boomer industry cohort transitions to retirement. I believe the Next-Gen industry cohorts will build core business models that provide commercial solutions to an environmental or social challenge and contribute measurable progress toward one or more of the United Nations Sustainable Development Goals (“SDGs”).

Basics of Estate Planning

Originally published: February 9, 2020

No one can predict the future, but one thing is for sure: If we leave unanswered questions about how to handle our affairs after we pass, life for our loved ones could become much more difficult. That’s why formalizing your wishes in an estate plan is an important aspect of financial planning that shouldn’t wait.

It’s never too early to begin thinking about your legacy. To get the process started, consider the following basic steps:

  1. Prepare a will. Your will is a legal document that spells out your wishes about who will inherit specific assets after your death. A properly drafted will can play a critical role in minimizing your estate’s exposure to taxes. If you should die without a legally binding will in place, courts may end up making decisions about who benefits from your estate, regardless of your best intentions. Be sure to review your will regularly.
  1. Consider a living trust. Explore living trust options if you have concerns regarding estate taxes, privacy, lawsuits or creditors. You might also establish a living trust if you want to specify how assets are distributed to heirs, to help prevent mishandling of an inheritance.
  1. Name your beneficiaries. Certain assets such as retirement plans (401(k)s, 403(b)s, etc.), IRAs, bank accounts and insurance policies allow you to designate beneficiaries. These forms take precedence over designations contained in a will. For this reason, it is important to update your beneficiaries when things change. Marriage, divorce, a move, birth of a child or death in the family are common life events that can trigger beneficiary updates.
  1. Assign a power of attorney. A power of attorney is a legal document that assigns the right to manage your affairs if circumstances arise that prevent you from doing so. Each state has its own specific rules to establish this legal arrangement. Designating a person to be a “durable” power of attorney means they can act as your agent, making medical and/or financial decisions for you when needed.
  1. Gather important information. Create a folder to house critical documents about your assets and obligations. This should include a copy of your will, deeds to property, car titles and other documents that show ownership of your assets. List all accounts where money is held, sources of income, bills and outstanding debts. Also list names, addresses, phone numbers and email addresses for anyone your next of kin may need to contact. Don’t forget to include user names, passwords and even answers to security questions to allow your survivors to access online accounts as well as your cell phone, voice mail and email accounts. Consider storing key materials in a safe deposit box, home safe or with a trusted adviser.

Preparing your estate is one of the most thoughtful things you can do for your loved ones. Be sure to consult with an attorney for assistance in creating the necessary documentation for your plan. Your financial adviser can review your estate goals to assure that your legacy intentions are consistent with your overall financial strategy.

Gregory A. Chona is a financial adviser with Ameriprise Financial Services in Crown Point.