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Is my municipal bond portfolio healthy?

By Jim Pratt-Heaney

More people are retiring than ever before. Income is becoming more relevant to their lives. Tax rates may head higher. Tax free bonds might make sense for your portfolio. But…

Given the poor fiscal health of many municipalities, and with many high-net-worth investors having a significant part of their financial assets in municipals, they must be extra careful with this asset class.

You should not be “passive” when it comes to determining the health of the bonds that you own or want to buy. It’s difficult for the individual investor, to look at a municipal bond and know what they are really getting unless they have significant time to investigate, or they hire someone to do the proper research for them. Even professionals have more difficulty getting information about municipal bonds than for example a stock, where they can get research reports or go to company websites.

The municipal bond market can be the Wild West. While underlying bond ratings are a strong indication of the quality of a bond issuer, investors rely on rating agencies and many municipalities do not provide timely updates on their credit ratings. Many bonds haven’t had their credit ratings updated since being issued. Is the quality of that bond the same many years after it was issued or has the municipality’s fiscal health deteriorated?

Your municipal portfolio should be reviewed by several unbiased professionals, not the person who built the original portfolio. Many advisors will review a portfolio without charge. There is much to review. Do you have all of your municipal bonds in one state? Does that make sense?

Should your portfolio be rebalanced from longer maturities to shorter ones? Conventional wisdom says that interest rates might rise soon. If so, the price of taxable bonds could fall, but not necessarily the price of nontaxable municipal bonds. Between December 2003 and September 2006 federal funds rose from 1.0 % to 5.25% yet municipal prices rose between 6 and 20% in value. Conventional wisdom was wrong.

When determining the balance of short- and long-term bonds, professionals need to factor in interest rate behavior. Many bonds have extraordinary call provisions which may result in a dramatic loss of income. Do you know which of your holdings could pay early and how to reinvest those proceeds?

Consider taxable bonds in your muni portfolio, even if you are in a high tax bracket. In today’s environment some municipal yields have dropped so low those taxable bonds after tax yields may be higher than in the municipals. Does it make sense to swap bonds to realize a taxable loss or gain?

Through active management an investor also retains the flexibility to navigate to the most attractive areas of the market away from troubled areas.

How much of my portfolio should be invested in municipal bonds? Remember when you were advised that you could determine your equity portfolio by subtracting your age from one hundred? Given longer life spans, that strategy certainly won’t work now. Careful planning is required to determine proper asset allocation. Remember that like all markets, the municipal market is complex representing pitfalls and opportunities for investors. And often current conventional wisdom doesn’t work.

In summary, the bond market is often as volatile as the stock market. There are opportunities to swap bonds, change maturities, and take advantage of potential rating upgrades etc. where capital gains can also be a major part of your total return in this asset class. It is vitally important that such an important part of your investment portfolio be reviewed by professionals.

June 2010