Retail investors can chose from three key “methodologies” when investing in municipal bonds, said Laurie Nichols, managing partner for SeaCap Investment Advisors, speaking Tuesday at a fixed-income forum sponsored by Concord, a wealth management company.
1. A passive bond ladder is a good option for clients with small portfolios and for true “do-it-yourselfers.” To create a bond ladder, investors purchase bonds with maturity dates that step out at intervals into the future. Cash from a maturing bond can be taken off the ladder or reinvested in a new muni bond at prevailing interest rates. Regular reinvestment helps protect investors from interest-rate fluctuations that can erode the face value of a bond.
o Pros: Bond ladders are fairly simple to implement and provide a way to manage income streams. They also eliminate the tendency toward “market timing,” which usually backfires on the retail investor.
o Cons: Bonds with long maturity dates are not as liquid as other investments. Retail investors can also be faced with a limited a choice of bonds to purchase in transactions that are very commission-driven. Self-directed investors might not be aware of the markups applied to bonds, making a lack of expertise a potential liability in a huge market with a variety of issuers, call structures, risk levels and coupons.
2. Actively managed bond mutual funds can be a good investment for clients who have small portfolios, but do not want to actively manage their bonds. An investor who purchases a mutual bond fund owns a share in the fund, but does not directly own the bond.
o Pros: These funds are simple to manage and are fairly liquid. Investors sell their shares of the fund to redeem cash, and are not burdened by the need to sell the underlying bonds. The funds also allow for greater diversification and some provide choice as to regions.
o Cons: There are no guarantees with mutual bond funds. The value of the funds can fluctuate and, depending on the market conditions, investors may be forced to sell at a loss. Managers pressured to increase yield may purchase a high percentage of funds subject to the alternative minimum tax or riskier bonds with lower ratings. The huge selloff that took place at the end of 2010 and beginning of 2011 shows that funds are vulnerable to huge outflows that can force fund managers to sell bonds to cover redemptions.
3. Separately managed municipal bond accounts gives investors access to an experienced account manager, and also allows the investor to hold individual bonds, not shares in a bond fund. The funds are a good choice for high net worth investors who can meet the account minimums.
o Pros: The funds are actively managed, yet allow for direct ownership of bonds, reducing the risk that investors will lose their initial investments. The funds can be customized to ensure the greatest tax-efficiencies for investors in each state.
o Cons: Separately managed accounts can be complicated to implement, and the portfolio is less liquid than a bond mutual fund. Individual bonds have to be sold in the marketplace and demand will vary depending on economic conditions.