October 2007

It sits in the backyard shed against a wall, covered in cobwebs. It’s your rickety old ladder. And though it may have sentimental value, it could be time for an upgrade.

The same might be said for a ladder of municipal bonds. While there are definitely advantages to having a portfolio of individual muni bonds, there are some new options being offered these days, such as a portfolio of tax-exempt mutual funds.

In both cases, middle- and high-income taxpayers appreciate the advantages of munis, whose interest payments are exempt from federal income tax.* But while the benefits of tax-exempt bonds are clear, the strategy of “laddering” maturities using individual securities might not be the most cost-effective way to go for everyone.

A muni-bond ladder is made up of several issues maturing at different times. Each rung on the ladder might represent a single bond coming due the year after the previous one.

On paper, the plan makes sense. By holding a bond until it matures, the ladder’s owners get back its face value. They also obtain regular interest payments at a fixed rate and have the ability to control if (or when) they incur capital gains taxes. Clearly, laddering is an effective strategy for some people and should not necessarily be discarded.

But the best-laid plans often go awry. As your bonds mature, it may make sense for you to invest the proceeds in a municipal bond fund rather than in more individual bonds.

“Lots of investors build their muni-bond ladder with the best of intentions, but then reality intervenes,” says Timothy Blair, manager of the Northern Short-Intermediate Tax-Exempt Fund. “An unexpected expense comes up and they need to sell their bonds prior to maturity. We see it on the trading desk every day.”

While an investor may still see some loss from selling a mutual fund, the difference mainly lies with the fund’s size and relative liquidity. These provide the fund manager sufficient flexibility to regularly liquidate bonds at prices that may help minimize the impact of market fluctuations. Plus, individual investors typically trade in relatively small increments, while funds can normally achieve an economy of scale that can be an advantage when it comes to pricing.

Stepping up. . .or down
There are other ways to fall off the ladder as well.

Because individual investors typically trade in small quantities, they lack the clout with bond dealers to narrow the gap between the bid and ask price on a bond. That “spread” could amount to a couple of percentage points, thus offsetting much of a bond’s yield.

“Mutual funds operate much more efficiently because we deal in large quantities and work closely with dealers,” Blair says.

And then there’s the matter of professional management.

Blair says that he can use Northern’s strong relationship with the dealer community to structure new issues in a way that could potentially perform better based on his outlook for interest rates. For example, he might buy a 15-year bond with a shorter 3-year call feature.

And why is that a good deal?

“Because the yield is higher, like a long-term bond, but the interest-rate risk is lower, like a short-term bond.”

Now that’s a step in the right direction.

Getting a leg up
Blair says that temporary supply-demand imbalances within the municipal market also give mutual fund managers a leg up on their ladder-climbing counterparts.

There’s usually a glut of bonds coming due during the summer, and laddered investors reinvest the proceeds. But all that demand pushes up prices and depresses yields. That’s when a professional manager might be inclined to sell, not buy.

Conversely, there’s also a seasonal component to supply, with municipalities rushing to borrow before the end of their fiscal year. The glut of supply pushes prices down and yields up. That’s when fund managers might be buying, not selling.

“The muni market is inefficient,” Blair says. “Professional fund managers are better positioned to exploit it.”

Balancing act
While the investment-grade tax-exempt market has experienced very few credit problems, investors should never take lightly the possibility that borrowers might default.

“Compared with taxable bonds, municipals have a much better credit profile,” Blair says, “but we still make credit analysis a top priority.”

That’s where the diversification and professional management that mutual funds provide can help.

Northern’s tax-exempt funds typically hold anywhere from 50 to 250 different securities, providing managers more flexibility through diversification. Plus, professionals trained in assessing credit risk scrutinize and monitor the creditworthiness of each issuer. And while their managers have the option of purchasing below-investment-grade bonds, currently all of Northern’s municipal funds’ securities are investment grade.

“Finally, a well-managed tax-exempt fund can lessen interest-rate risk. A bond fund’s share price normally will go down when rates go up. But maturities could be shortened if rates seem poised to rise, thus reducing the effects of higher yields.

“We can make adjustments that mitigate the impact of rising rates,” Blair says. “We are in the market every day.”

Covering all rungs
Northern recently introduced the Short-Intermediate Tax-Exempt Fund to give clients a full menu with which to build a portfolio of tax-exempt bonds.

The Northern Municipal Money Market Fund** provides a tax-exempt home for money that needs to be kept liquid to meet ongoing expenses and emergencies.

At the other end of the maturity spectrum, the Northern Tax-Exempt Fund holds long-term bonds, which usually means the highest yield but also the most resale price risk.

“That Fund works best for money that you don’t expect to need for a while,” Blair says.

Between those two extremes are the Northern Intermediate Tax-Exempt Fund (target maturity of three to 10 years) and the new Northern Short-Intermediate Tax-Exempt Fund, which holds bonds whose average maturity is usually between one and six years.

“In terms of credit quality, it’s very similar to the other funds that we run,” Blair notes. “We particularly like solid general obligation, essential service and pre-refunded bonds. But we always try to focus on the higher-quality credit securities.

“All of Northern’s tax-exempt funds seek to generate current income that is exempt from regular federal income tax. Investors should keep in mind, however, that a fund’s interest income may not be exempt from state or local taxes, and a portion of it may be subject to the federal alternative minimum tax. And, a fund’s capital gain income generally will not be exempt from tax.”

Some munis yield about 85% of their Treasury counterparts. So even investors who are not in the highest tax bracket should consider municipals.

“Munis are cheap, generally safe and have important tax advantages,” says Blair. “They may make sense for investors in middle tax brackets.”

So the next time you go looking for that ladder, check out the new way to scale the tax-exempt heights.

*Income may be subject to AMT, state and local taxes.

**Investments in money market funds are not insured or guaranteed by the FDIC or any other governmental agency. Although the Funds seek to maintain a value of $1.00 per share, it is possible to lose money.