Are Tax Breaks Enough to Make the Case for Individual Municipal Bonds?

On this episode of The Long View, Lyle Fitterer, senior portfolio manager and co-lead on the municipal-bond sector for Baird Advisors, shares his thoughts on what parts of the municipal-bond market are worth investing in, what municipalities to avoid, and whether it’s worth it to own individual municipal bonds.

Here are a few excerpts from Fitterer’s conversation with Morningstar’s Christine Benz and Amy Arnott.

The Pros and Cons of Individual Municipal Bonds

Amy Arnott: From a portfolio perspective, we’ve talked to a lot of financial advisors who do like to use individual municipal bonds with their clients, partly because they want to match the maturity to the investor’s holding period, and it’s easier to take advantage of the state and local tax breaks. Are those legitimate reasons to use individual bonds as opposed to a bond fund, assuming that you can buy enough of them to have a diversified portfolio?

Lyle Fitterer: I think that’s the ongoing debate is, does it make sense because of the specific tax requirements and benefits that you get? So, if you can build a truly diversified portfolio and get away from these kinds of single-obligor risks, I think in many cases, owning some individual bonds probably makes some sense, especially in some of your very high-tax states like New York or California.

That being said, I still think that you want to have a portfolio that’s 100% invested in the particular state that you live in because of that benefit. We would argue no, and we’ve had these conversations. We manage some large accounts for what we call insta-viduals, which are basically very wealthy individuals, and so they have diversified portfolios, but do you want to have 25% or 50% of your portfolio, or even higher, in California or New York? And really looking at, because of some of these specific state risks or specific ESG risks that we talked about earlier, and the conclusion we came to is no. So, maybe you need to think about it in terms of, hey, I’ll own some individual bonds in the state that I’m in because of that benefit from a tax exemption. I’ll do it in a very diversified fashion, but then look for an open-end mutual fund or an ETF or some other pooled vehicle where you can get national exposure; it diversifies some of that risk away for you. You can do it on a diversified basis. You can add lower-quality credits to your portfolio because you generally don’t want to buy those lower-quality credits in an SMA because, again, you can’t get the diversification that you’re looking for.

So, within a mutual fund, you’ll get higher ed, you get healthcare, and you can probably make up the difference in terms of income on a tax-adjusted basis from those credit sectors, and so put part of your money in that pooled vehicle, and then that also gives you some liquidity. Mutual funds and ETFs have much better liquidity than individual bonds. So, that might be a way of thinking about it rather than just simply saying, hey, I want that SMA because I want to be able to manage that maturity risk or that tax risk that I have in my portfolio.

The other thing is, there are some fixed maturity funds and other vehicles that have popped up out there. Again, I think in terms of, hey, having a fixed maturity and you know that at X period in the future, you’re going to get paid back on your investment and it’s going to roll down the curve and what was a five-year will become a four-year and then a three-year and a two-year, like you’d get into an individual bond.

The difference in those pooled structures is that they don’t close after they get initially invested. So, if the first person gets in and they buy a 5% bond at 10 years and then rates rally, and now rates are 4%, and then investor number two gets in, now you have to buy another bond with that same maturity, and you buy it at 4%. So, now the yield on your portfolio—book yield goes from 5.0 down to 4.5. So, now you’re splitting some of that 5 with that new investor, and then also your price on that particular entry point actually went up on that mutual fund because the price has gone up. So, you’re not guaranteed to get that car on that mutual fund like you would in an actual maturing bond, if that makes sense.

Have the Trading Costs Improved for Individual Munis for Small Investors?

Christine Benz: I wanted to ask about the trading costs for individual munis. I remember hearing from our analysts that they could be quite punitive for small investors, that they really get killed on the bid-ask spreads. Has that gotten better for small investors venturing into individual munis?

Fitterer: It definitely has gotten better. There are a lot of electronic platforms that are out there, algorithm-driven platforms. You’re still going to pay a price. So, instead of it being a point or 2 points, maybe it’s a 0.50 point or maybe it’s even a 0.25 point. So, the cost has come down for individual portfolios, and that can vary over time. So, on a bad day when rates are going higher in the Treasury market, and the bid has slipped, maybe it is a point or two or something like that. But on good days, again, it could be a quarter to a half a point. Now, if you think about that though, even a half a point, again on a bond, and if you think about it for an entire portfolio, if you have to liquidate your portfolio and it costs you a half or a point, that’s a lot of basis points that you lose in terms of an expense ratio that you’re paying on a fund because you had an liquidity event and actually had to liquidate that portfolio.

So, it’s gotten better. Obviously, it’s still more efficient in many cases for these pooled vehicles to trade a larger size, and you’re not subjected to that, and you have the daily liquidity that you would get in those pooled vehicles. But if you truly do want an SMA, it has gotten better, and your provider should be able to get you better execution because of the different systems and the trading platforms that are out there.