The high yields on municipal bonds are tempting, but you need to be mindful of these hidden risks

What may surprise you is that yields on investment-grade municipal bonds (“munis”) are higher than they are for U.S. Treasury bonds, which are subject to federal income taxes. But you need to use a careful strategy to avoid two important risks.

Philip Palumbo, the founder and CEO of Palumbo Wealth Management in Great Neck, N.Y., says municipal bonds provide a “good balance” for large portfolios that also include stocks. But he also sees elevated default risk for munis because the coronavirus pandemic and economic shutdown have caused a tremendous decline in states’ tax revenue. A $3.1 trillion national budget deficit makes the prospect of a federal bailout of states less likely.

Palumbo recommends avoiding concentration in the municipal bonds of a single state, even if you are living in one with very high income taxes, such as New York or California. During an interview, he said the advantage of avoiding state income taxes on muni bond interest is “minimal when compared to the extra risk you are taking.”

So go with a varied portfolio from many states, be content to avoid federal income taxes and tolerate state income taxes.

As an active money manager, it’s no surprise that Palumbo believes an active approach to managing bond portfolios is best, not only because of the higher credit risk for certain types of munis (which is explained below), but because professional bond managers can take advantage of disruption in pricing, such as what we saw in March and April.

But for this, he turns to firms that specialize in running municipal bond portfolios for investment advisers’ clients. One of these is Clinton Investment Management, which is based in Stamford, Conn., and runs about $1 billion in bond portfolios, working with nearly 80 outside investment advisers.

“The value proposition is very strong” for municipal bond investors who hold their own bonds, rather than shares of a mutual fund, Palumbo said. “Separately managed accounts can often save investors a lot of money relative to actively managed funds.”