The pitfalls of municipal bonds in this highly idiosyncratic market, especially when investing in an index-based fund.
Addition by subtraction. That’s when a team improves by getting rid of a player who is dragging down the whole squad. It can also be like that with bonds. Knowing what to leave out of a fixed-income portfolio can be as important as what to include. And index-based municipal funds—increasingly favored by many investors—are based on the biggest, most indebted credits, not the best ones.
That stands in contrast to index-based equity funds. The biggest stocks in capital-weighted indexes such as the S&P 500 get there by dint of their success. But unlike stocks, which have unlimited upside, bonds only provide interest and repayment of principal, plus the potential for loss. Add to that the idiosyncrasies lurking in many muni bonds and you see how subtracting risks can meaningfully add to returns.
Take what has historically been among the most gilt-edged sectors of the tax-exempt bond market: issues from colleges and universities. Education bonds account for a not-insignificant 7% of the muni market, according to Bloomberg data.
The obligations of elite institutions are sought out because of their substantial endowments, high acceptance rates, and relatively infrequent borrowings. But, says Jack Ablin, chief investment strategist at Cresset Capital in Chicago, there has been a “Darwinian winnowing” among U.S. colleges and universities. Even a top institution such as the University of Chicago recently saw its credit rating lowered to AA—still a high grade—from AA+ by Fitch Ratings, he says.
Amid clashes with the Trump administration, Harvard University reported an operating loss of $113 million for 2025, a reversal of the previous year’s $45 million surplus. Harvard retains a top triple-A ratings from major credit raters, but in the past year it has had to tap the muni market with both tax-exempt and taxable bonds.
Harvard sold $675 million of bonds earlier this year after issuing a total of $1.2 billion in 2025. That’s despite having a $56.9 billion endowment at the end of its last fiscal year. One problem: Some 80% of the endowment is restricted to specific academic purposes by donors and can’t be spent on operating shortfalls.
In addition, endowments pay taxes on their investment gains. Those taxes rose under the One Big Beautiful Bill Act in 2025, to as high as 8%. Ablin estimates that could collectively cost Harvard, Stanford University, Yale University, Princeton University, and the Massachusetts Institute of Technology some $1 billion over five years.
Ablin, who serves on two university and college boards, believes smaller, lower-profile institutions are even more vulnerable than the top schools because of declining enrollment and high fixed costs, especially for tenured faculty. He sees only half of the some 4,000 private colleges surviving over the long term. All of which comes as increasing numbers of parents and children question the value of a costly four-year degree as graduates face the toughest job market in years, in part because of the effect of artificial intelligence on entry-level jobs.
So, despite the fact that the sector seems to be deteriorating, Ablin doesn’t see bargains in college and university bonds, even among elite, well-endowed institutions.
This view is seconded by Andrew Clinton, eponym and chief executive of Clinton Investment Management, a municipal specialist asset manager in Stamford, Conn. Yields on top-grade Harvard bonds, he says, don’t offer a lot of compensation for their admittedly remote credit risk.
And Clinton sees even greater risk from a number of California bond issuers that may be affected by wildfires hitting the Golden State. In particular, he points to the litigation risk of various public utilities in Southern California.
Moody’s Ratings earlier this year downgraded 13 Los Angeles–related credits, including the city along with its Department of Water and Power, known as LADWP. Moody’s action followed a Los Angeles Superior Court ruling that allows LADWP to be sued for failing to supply enough water to fight the January 2025 Palisades wildfires.
Muni bond investors are typically risk-averse individuals who have made money elsewhere and want to preserve wealth, Clinton says. But their preference for shorter-term, top-grade securities tends to make them too conservative in their muni portfolios. Better value can be found in A-rated munis, which he says have a low default history comparable to AAA corporate bonds.
Most muni buyers also tend to stay with credits in their own state to shelter state and local, along with federal, taxes. In-state demand tends to lower yields in high-tax states. Investors, he says, ought to diversify nationally to reduce local risks.
As a result, Clinton contends that Californians should look across the nation for their muni investments, if not pick up stakes and move, and write a check to Sacramento for taxes on out-of-state bonds. Ditto for New Yorkers, who gravitate to Empire State credits for the same reason.
Ironically, however, the two top states in the iShares National Muni Bond exchange-traded fund are New York, with 19.61%, and California, with 17.34%. The biggest national muni ETF, at $44.66 billion, is heavily weighted by the biggest issuers that Clinton would advise residents of those states to avoid investing in it.
The attraction of 4.25% tax-free municipal is that its yield is nearly equivalent to a 9% fully taxable corporate bond for investors in the top brackets, Clinton points out. That would be competitive with something like private credit, without its risk, leverage, and illiquidity.
Write to Randall W. Forsyth at randall.forsyth@barrons.com