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Reasons to Consider Tax-Free Bonds

Robert Powell says investors should look at tax-free bonds, as rates are rising and demand is exceeding supply.

Tax-exempt bond funds continue to attract new money and with good reason.

Many high-income investors, including retirees, are concerned about the prospects of higher tax rates.

And with demand exceeding supply, rates are rising. The yield on AAA-rated municipal bonds is now 1%, according to FMSbonds.com.

With interest rates at low levels, it’s hard to be excited about bonds, said Daniel Kern, the chief investment officer at TFC Financial Management.

“However, municipal bonds are one of the ‘better houses’ in a bad neighborhood,” he said.

   >> Plus, from Robert Powell's Retirement Daily on TheStreet: How to Generate Income In Retirement During A Period of Historically Low Interest Rates

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Others seem to agree. Year-to-date through June 18, tax-exempt paper registered a positive return over 1%, while other fixed income sectors incurred losses, according to a recent UBS  (UBS) - Get UBS Group AG Report report. And UBS expects that trend to continue. “We believe the asset class is still well-positioned to outperform most other types of fixed-income securities through the end of the year,” the authors of the UBS report wrote.

In addition to the likelihood of an increase in tax rates bolstering demand, Kern noted that municipal finances are improving. Government support, rising home prices, improving employment and rising stock market values provide a backdrop in which ratings upgrades far exceed downgrades.

“Unfortunately, municipal spreads have meaningfully tightened compared to the wide spreads of a year ago,” said Kern, “I’d advise that investors remain cautious; reaching for yield is a natural inclination for investors with rates this low.”

Kern said there is not a lot of value in short-term bonds today but he does recommend keeping a significant portion of the muni allocation in shorter-term bonds and in cash, which provides the opportunity to lengthen maturities if rates rise during the second half of the year or in early 2022.

In addition, Kern noted that there are opportunities to enhance yields by investing in lower quality debt — either the lower tiers of the investment-grade universe or in non-investment grade municipal bonds. “Selectivity in this segment of the bond market is critical, so I recommend investing with an actively-managed fund rather than an index fund or ETF,” he said.

For those looking for a starting point for their research, Morningstar  (MORN) - Get Morningstar, Inc. Report recently published a list of municipal-bond funds and exchange-traded funds that earned the rating company’s highest rating—a Morningstar Analyst Rating of Gold.