THE BUZZ OVER MUNICIPAL BONDS

Returns are high compared to Treasuries.

High-income investors who want reduced risk and better tax efficiency have long turned to municipal bonds (and municipal bond funds). While the credit crunch affected the muni bond market last year, demand is still high for these debt instruments – people who want a little extra yield look at muni bonds and see them paying higher returns than bank certificates and U.S. Treasuries.

If you’ve thought about going this route, you need to shop carefully – and with the guidance of your financial or tax advisor. Credit ratings matter. Additionally, some municipal bond funds invest in highly complex ways. Generally, though, municipal bonds are performing very well relative to Treasuries, CDs and other common fixed-income investments. (A peek at Treasury yields on February 6 showed the benchmark 10-year note at 2.96%, the 30-year bond at 3.66%, the 2-year note at 0.98%, and the 3-month T-bill yielding 0.28%.¹)

Tax-free benefits. The interest income on municipal bonds is usually tax-exempt. In comparison, CDs are taxed.

Figuring the taxable-equivalent yield of a muni bond is a real eye-opener. The taxable-equivalent yield of a municipal bond equals the yield divided by (1 – Federal Marginal Tax Rate).² For example, if a muni bond has a 5% yield and you find yourself in the 35% tax bracket, the calculation is .05/1-.035%, or .05%/.65%. The taxable-equivalent yield is 7.69%. Can you get that kind of yield from a CD or Treasury?

Look for the label: AMT-free. Some muni bonds pay rates that are subject to the Alternative Minimum Tax. Some don’t. This is why you want to look for AMT-free municipal bonds and municipal bond funds.

Muni bond ETFs & CEFs. While most exchange-traded funds (ETFs) focus on stocks, you can find some municipal bond ETFs. A muni bond ETF doesn’t mature like a muni bond, and you can lose principal – but with the low annual fees of an ETF and attractive yields to maturity, these funds are getting some looks.

Also, there are closed-end municipal bond funds (CEFs) available. These funds often use leverage: they borrow money at low short-term interest rates and buy longer-term bonds that pay higher rates. This move can improve a CEF’s yield and dividend ratio, but it also introduces more risk. If short-term interest rates go up and long-term rates go down, that translates to a lower payout and lower net interest income. Some CEFs offer insured muni bonds. (The insurance is provided by an insurance company, not the FDIC.) The insurance guarantees the payment of principal and interest if the issuer defaults.

If you invest in municipal bond ETFs or CEFs, it’s important to remember that you are not buying a bond – you are buying shares in a fund.

What’s the risk of default? Many state and local governments are struggling in the recession, so the default risk for municipal bonds has undeniably risen. Historically, however, the risk of a city or state going belly-up has been incredibly low. No state has ever gone bankrupt, although a prominent American county once filed for bankruptcy (Orange County, CA, in 1994) and New York City and Cleveland nearly did in the 1970s.³

Cities and states issue revenue bonds to raise funds for infrastructure projects and general obligation bonds to raise fast capital. It is almost inconceivable that a general obligation muni bond would default, as state and local governments could simply raise taxes to generate the money owed to investors. Project-specific revenue bonds contend with more risk. However, you have the Obama administration ready to fund massive infrastructural improvements, and the White House has made it clear that much of it will be carried out on state and local levels.

Want to learn more? Before you get into the muni bond market, you will want to tax to your financial advisor and/or tax advisor. The current credit rating and the long-term rating of the issuer are important, and you don’t want your yield to be subject to the AMT. You also don’t want to be redundant and put a tax-exempt bond into a tax-exempt account like a 401(k) or an IRA. Consult with your trusted advisor to discern what move might be right for you.

These are the views of Peter Montoya Inc., and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information.

Citations.

¹ money.cnn.com/2009/02/06/markets/bondcenter/credit/?postversion=2009020611 [2/6/09]

² forbes.com/2008/07/03/commandments-municipal-bond-pf-guru-in_mc_0703advisersoapbox_inl.html [7/3/08]

³ forbes.com/2009/01/17/municipal-bonds-bankruptcy-pf-in_mc_0119tmunibonds_inl.html [1/17/09]