A Bond Backfire after Racing to Buy Long-Term Treasuries and Sell Tax-Exempt Funds

Investors in bond funds made two major moves over the past year. Many bought long-term U.S. Treasury funds to obtain higher yields at what they thought was relatively low risk. During the same period, many investors sold tax-exempt bond funds because of concerns about the finances of local governments.

Both were problematic. Those who bought long-term U.S. Treasury funds took on a lot more risk than they anticipated, and those who sold tax-exempt funds were not discriminating enough among the types of municipal bonds.

Let’s consider what drove investors to move about $500 billion into long-term bond funds holding U.S. Treasurys and investment-grade bond funds in the first place. Many of them had been holding money-market funds and wanted higher yields; they chose high-quality bond funds to minimize their exposure to risk.

And they did minimize their exposure to credit risk: Treasury bonds won’t default, nor will most investment-grade bonds. Yet they unwittingly took on a huge amount of interest-rate risk — when interest rates rise, prices of high-quality bonds fall.

In October, the interest rate on 10-year U.S. Treasurys was 2.3 percent. By February, it had climbed to 3.6 percent, though it has recently fallen back a little. That 1.3-percentage-point increase in the interest rate on 10-year Treasury bonds translates into a 5.6 percent decrease in their price — a disaster for investors who thought they were opting for safety.

The worst may be yet to come. Interest rates on 10-year Treasurys have a long way to rise before they reach historical averages. Over the past half-century, the median rate for 10-year Treasurys has been about 5 percent.

So how can bond investors obtain higher yields than money-market funds without taking on so much interest-rate risk? One possibility is to buy high-quality bond funds with very short maturities — in the range of one to two years. Although such short-term funds will have lower yields than long-term Treasury funds, they will also have much less exposure to sharp rises in interest rates.

A second option is to buy funds that invest in high-yield bonds, commonly called junk bonds. Such bond funds have higher yields than Treasury bond funds and much lower interest rate risk. But junk bond funds do involve a significant amount of credit risk — some of the bonds they hold will default. It’s important to choose a junk bond fund that reduces credit risk by holding a well-diversified portfolio and avoiding the lowest-rated bonds.

Look overseas

Funds that invest primarily in emerging-market bonds are another option. Like junk bond funds, emerging-market bond funds have higher yields than Treasury bond funds — and less exposure to interest-rate risk. But again, emerging-market bond funds entail a great deal of credit risk. The key is to find a diversified fund that invests primarily in the emerging markets that have risen to investment grade, such as Brazil and Taiwan.

A final idea is to invest in funds that primarily hold TIPs — Treasury Inflation-Protected Securities. Such Treasury bonds have minimal credit risk and pay a relatively low base rate of interest, plus additional interest based on the rise in U.S. consumer prices. If interest rates rise sharply, consumer prices will generally follow, so investors would receive an additional interest payment on TIPs.

However, a TIPS fund should be bought only in tax-sheltered retirement accounts, such as a 401(k) plan or individual retirement account. The extra interest from TIPS is not paid in cash; it accrues annually and is paid when the bond matures. During the interim, the accrued interest counts as income, so taxes are due despite the lack of cash payments. This can be avoided by holding a TIPS fund in a retirement account not subject to income taxes each year.

While investors inadvertently ran toward risk in taxable bond funds, they ran away from any kind of risk in tax-exempt funds, also called municipal bond funds. These funds buy bonds that are exempt from federal income taxes and are issued by cities and states — nearly all of which recently seemed to be facing short-term revenue shortfalls and growing long-term pension liabilities. Investors — afraid they would end up with the short end of the stick in a budget crisis — moved more than $30 billion out of tax-exempt funds in the three months ended in January.

The outflows signaled a dramatic shift in attitude toward municipal bond funds. Investors thought they understood the risks in the market, which seemed to follow a strict hierarchy.

Insured tax-exempt funds were considered extremely safe. As the name implies, all of the bonds in these funds are covered by an insurance policy, issued by a specialized municipal bond insurance company such as Ambac or MBIA. This insurance was designed to guarantee that the bond would make promised payments to investors.

General municipal bond funds were seen as only slightly more risky than insured funds — but were still deemed quite secure because they invested a large part of their assets in bonds backed by taxes. These might be general obligation bonds, which states and cities could use any tax revenue to pay, or special tax bonds, which are repaid from the revenue from a specific tax, such as a gasoline tax. Because the issuers of these bonds have the power to raise those taxes, defaults in this sector are very rare. In fact, no state — and only a few cities — has ever tried to walk away from its general obligation bonds.

The tax advantage

These general municipal bond funds come in two varieties: national funds, which invest in bonds from around the country, and single-state funds. National funds are naturally more diversified — and therefore less risky. But many investors opted for the single-state variety because they have an extra tax advantage: Their income is exempt from local, state and federal taxes.

At the other end of the risk spectrum are high-yield tax-exempt funds. These funds invest almost exclusively in revenue bonds, which are issued to fund a specific project, such as a sewage treatment plant or a hospital, and can draw only on revenue from that project to repay investors.

That revenue usually declines during an economic downturn, so it was no surprise that analysts started talking about more revenue bond defaults because of the recession.

Rather, the surprise was that analysts began to consider the possibility that a state or major city would default on its general obligation bonds.

Analysts noticed that a few state constitutions did not provide bondholders much protection. For example, New York’s constitution requires that it pay pensions to retirees before it pays investors. Suddenly, general municipal bond funds stopped looking like sure bets.

Insured municipal funds also started to look less foolproof when the insurance companies providing the coverage ran into financial difficulties during the credit crisis because of losses in their other lines of business. Many bond issuers stopped buying insurance, which no longer provided the comfort investors were seeking. With fewer insured bonds on the market, some fund companies even eliminated insured funds from their portfolios.

Given this uncertainty, investors sold tax-exempt bonds indiscriminately. But they should reconsider by distinguishing carefully among different types of bond fund holdings.

In our opinion, default rates in the municipal market aren’t going to be as high as the doomsayers predict. Many states have constitutions that give high priority to bondholders; for instance, in California, only education ranks higher than paying bondholders when it comes to state spending. Cities generally cannot default without permission from the state government, and states have been reluctant to give them the go-ahead, because they often end up footing the bill. Bridgeport, Conn., learned this lesson when it tried to default on its bonds.

At the same time, the higher yields on municipal bonds have made them more attractive — and they provide some cushion against default for diversified investors. In fact, municipal bonds now yield almost as much as U.S. Treasurys, even though the taxes on municipal bond income are much lower.

Diversify as much as possible. They’ll get almost as much yield from a national fund as from a single-state fund — even adjusted for taxes — and they take on a lot less risk. Risk-averse investors should shy away from funds with a large portion of revenue bonds.

Following the crowd may not be the most fruitful approach to choosing bond funds. By piling into long-term Treasury funds and fleeing general municipal funds, investors haven’t been getting the best combination of risk and return.