What’s Wrong with a Municipal Bond Fund?

Photo by Peter Dazeley via Getty Images.

Paul Solman answers questions from the NewsHour audience on business and economic news here on his Making Sen$e page. Here is Wednesday’s query:

Peter Stratton: I’m interested in current income only. Why shouldn’t I invest all my cash assets in high yield municipal bond funds? As long as my current income is maximized, I’m not at all concerned about growth.

Paul Solman: You may not be concerned about growth, but you ought to be about inflation. Let’s say you buy into a high yield municipal bond fund, as my wife and I do with our “cash” — the money we use for transactions bigger than those in our checking account. But, as I ask whenever I answer a question like yours, suppose inflation strikes. Then what happens? Suddenly, interest rates go up to include that inflation. Why? For the obvious reason that if you loan somebody money that’s losing its value (via inflation), you want to be paid back the same real amount. That means an inflation adjustment, which is built in as a higher rate of interest.

If interest rates rise, the value of your municipal bond fund will fall. Why? Because new municipal bonds will have to pay a higher rate of interest, due to inflation, to attract investors. The old municipal bonds in your fund will then be worth less, causing the value of the fund to decline.

Sorry, but that’s how it goes.

Oh, one more thing: If a final fiscal cliff deal were to use the Bowles-Simpson Commission report as its template, the interest on municipal bonds would no longer be deductible from federal taxable income. Old bonds would be grandparented in but the implication would seem to be: if you committed to buying municipal bonds, buy them now.

This entry is cross-posted on the Rundown — NewsHour’s blog of news and insight.

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