How a crisis can benefit your portfolio

Pity the municipal bond investor. One day he is basking in self satisfaction because his shrewd investments in public works projects not only help keep cities running but also boost his income by keeping most of his earnings away from the tax men. The next, someone's yelling at him to get out of the water.

Every few years there's an event that makes the municipal bond market seem dangerous. In 2010, investors fled municipal bonds, primarily on the forecast of one prominent market analyst who predicted that numerous state and local bond issuers would soon default on hundreds of billions of dollars in debt.

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This time the shark sightings are in the Caribbean and the Great Lakes. Last summer the major ratings agencies started to ratchet down the ratings of Puerto Rican muni bonds because the U.S. territory is still plagued by large deficits and a weak economy. By February Puerto Rico's $70 billion worth of municipal bonds were no longer investment grade. Illinois, which already has the worst credit rating among the 50 states, is struggling with how to address a potential budget shortfall of almost $2 billion. And Detroit, which has had fiscal problems for decades, became the largest city ever to declare bankruptcy, with some $15 billion in liabilities.

Although those events were admittedly high profile, they were isolated, running counter to the larger trend of many state governments experiencing surpluses instead of deficits. But just as in 2010, some muni bond holders raced for the exits. In the second half of 2013, they had pulled out around $40 billion from the $600 billion muni bond fund market. Muni bonds lost 2.6 percent in 2013, as measured by the Standard & Poor's municipal bond index.

Unique Tax Advantage

You probably own Puerto Rican bonds if you invest in a municipal bond mutual fund. Of the 20 largest such funds, all except two own them. Even when muni fund managers are designing a fund with California investors in mind, they may buy Puerto Rican bonds if there aren't enough opportunities in their funds' home state.

So a muni bond fund designed for, say, Ohio residents might purchase Puerto Rican bonds if Ohio muni bonds are in short supply, or if they're too pricey. One reason: Puerto Rican bonds are tax-free in every state in the union. An Ohio muni fund, on the other hand, doesn't help its owners by buying, say, New York State munis because income would still be taxed.

Furthermore, Puerto Rican bonds are free from state and local taxes. Income from many types of local municipal bonds are free from federal tax but not from state or local. For someone in the 28 percent federal tax bracket, a municipal bond yielding 8 percent is equivalent to a taxable bond with an 11.1 percent yield. But if his combined federal and state tax rate is 35 percent, Puerto Rican bonds yielding 8 percent jump to a 12.3 percent tax-equivalent yield.

What To Do

Although we don't condone timing the market, crisis periods can be a good time for investors to purchase munis, just as in 2010. Eventually, the swimmers go back into the water and muni bond returns snap back. In 2010 muni prices reeled for a number of months, but fortunately for holders who didn't sell, the forecasted defaults never materialized. Historically that has been the case. In 2010 the default rates for munis remained the same as ever—low to nonexistent. Less than two-tenths of 1 percent of municipal bonds default annually.

In our view 2014 isn't exceptional. Though Detroit and Puerto Rico are certainly large financial concerns, they are more isolated cases instead of a tip of some larger municipal bond iceberg. Puerto Rico, for example, was still able to issue $3.5 billion in new municipal bonds in March. And even some investors have decided to dip a toe or two back into municipal waters: In recent months money has flowed back into municipal bond funds. For those investors willing to ride out what's left of the panic, there's a reward of tax-free investing at discounted prices.
—Chris Horymski