Last Updated: September 14, 2009
Americans are pouring money into long-term municipal bond funds at near-record levels, according to a published report. Indeed, investors put $1.5 billion into what are also called tax-exempt funds during one recent week, according to AMG Data Services. And that was the highest amount since AMG started keeping records in 1992.
There is good reason why this is happening. First, fund dividends from municipal bond interest are generally exempt from federal income tax and, in some cases, state and local taxes as well, according to the Investment Company Institute. What's more, such funds are performing nearly as well as the Standard & Poor's 500 index, posting an average return of 14.3 percent through early September. Plus, there's the prospect of higher income tax rates in the future.
While you might be tempted to join those investors searching for relatively high, tax-free income, it's important to consider 1) the risks that come with long-term municipal bond funds, 2) your alternatives and 3) how such funds fit in with your overall investment and financial plan.
As with other funds that invest in tax-free or taxable bonds, the major risks include interest rate risk, credit risk and pre-payment risk. Interest rate risk speaks to the notion that the value of the bonds fluctuates as interest rates rise and fall. When interest rates rise, the value of bonds typically decline. When interest rates decline, the value of bonds typically rise. Longer-term bonds tend to fluctuate in value more than shorter-term bonds, according to the Investment Company Institute's Guide to Understanding Mutual Funds. To compensate for that risk, long-term bond funds also have higher yields than short- or intermediate-term bond funds.
The other major risk is credit risk. Tax-free bond funds typically invest in the debt obligations of state and local agencies that are dependent on tax receipts. And when tax receipts go down, as is the case in the current economic environment, the risk of default rises. Moody's Investors Service recently assigned a negative outlook to the creditworthiness of all local governments in the United States.
Given those risks, FPA member, Michael G. Orf, CFP®, of Orf Capital Management, said "You might be wise to consider the alternatives to long-term municipal bonds. Those being intermediate-term municipal bond funds." Long-term bond funds tend to invest in bonds that have maturities of 10 years or more while intermediate-term bond funds tend to invest in bonds that have maturities of three to 10 years. Thus, intermediate-term bond funds or intermediate-term tax-exempt ETFs are likely to be less volatile than long-term bond funds. Orf suggested that "there is too much risk with long-term municipal bond funds because interest rates will eventually turn up."
Yes, the yields or returns on intermediate-term bond funds will be less than that associated with long-term bond funds right now. But that's why it's important to have an investment and financial plan in place, say financial planners. Instead of chasing hot stocks or funds, as many Americans are now doing, an investment and financial plan will establish the investments that best meet your various short- intermediate- and long-term financial goals. So while a long- or intermediate-term tax-exempt bond fund may be right for you, such investments should only be considered in the context of your overall financial and investment plan.
If you don't have a financial plan, consider working with a financial planner. A financial planner can take you through a process designed to help you identify your goals, time horizon and risk tolerance. Find a financial planner.