After the past year of massive turmoil in the economy and the markets, investors are wondering where they can invest that is relatively safe and smart and provide a higher return than cash. Tax-free municipal bonds can provide some stability and a reasonable after-tax return for many investor portfolios. It is a virtual certainty that income tax rates will be going up (especially for the "rich") over the next few years to pay for all the huge government borrowing and spending that is going on right now. Social security and Medicare also need increased "funding" from tax revenues. Increasing income tax rates make tax-free municipal bonds more attractive relative to other investments. Historically Muni's have performed well during periods of rising tax rates. Municipal bonds appear attractive relative to US treasury bonds and cash right now because they offer higher yields, lower taxes, and only slightly higher risk (depending on the state) in my opinion.
Muni Bond Investing Basics
Credit risk.
How safe is the state or municipality that is standing behind the bonds? My advice right now with all the municipal budget shortfalls is to stick with safer credits and higher rated bonds. General obligation (GO) bonds are usually safer than revenue bonds because they have the full taxing authority of the state behind them. California is currently having trouble and is issuing IOU's rather than paying their debts.
Interest rate risk.
Bond prices move in the opposite direction of interest rates. How much your bond price will go up or down is directly related to how long the term of the bond is. Long-term bonds (10-20 years) are much more volatile (risky) than shorter term bonds (1-5 years). I recommend sticking with the relatively safer short-term or intermediate term bonds. Generally the more credit risk and the longer the maturities of the bonds you hold, the higher the yield on the bonds. Higher risk=higher yield.
Is It All Tax-Free?
If you buy a national muni bond fund your interest income will be free of federal income taxes (but not state income taxes). If you buy a state muni bond fund that owns bonds from your home state this interest income will likely be "double-tax free" for both federal and state income tax.
Your Income Tax Rate?
Muni bonds make more sense if you are in a high tax bracket. If you are in a low income tax bracket you may be better off (after taxes) owning taxable bonds. Right now muni bond yields are very attractive relative to taxable bond yields so that muni bonds make sense for investors even in some of the lower tax brackets.
Where Should I Own Them?
Muni bonds should be owned in your taxable brokerage accounts, and not in your IRA or 401K accounts because income in those accounts is already tax-deferred.
Tax-Equivalent Yield? What's that?
To compare the yield on a muni bond to a taxable bond you take the muni bond yield and divide it by the inverse of your marginal tax rate. If your muni bond yield is 3% and you have a 40% marginal tax rate then the tax-equivalent yield is 3%/(1-.4) = 5%. That 5% is your tax-equivalent yield and that is the rate required on a taxable bond to beat your 3% muni bond yield.
Should I buy individual bonds or a muni bond fund?
The benefits of investing directly in individual muni bonds is that you can avoid the fund expense ratio and can pick and choose which states, maturities, and credits you want. You can create your own customized muni bond portfolio and can ladder the maturities if you wish. The advantage of buying muni bonds in a fund is that you get professional management, increased diversification, and a simpler and easier investment process for you. For most investors who are not bond experts using a muni bond fund will likely be best. What are some low-cost muni bond fund options?
Fidelity Minnesota Muni Bond Fund (FIMIX)- For Minnesota Residents Only
This is a 4-star rated mutual fund at Morningstar. It is a double tax-free fund (federal and state) for Minnesota residents. The average maturity of the bonds in the fund is 7.1 years and the average duration is 6.5 years. 70% of the bonds are rated AA or better (the top 2 credit ratings). Over the past 1, 3 and 5 year time periods this fund has ranked in the top 10% of its competitors in this category according to Morningstar.
I-Shares National Muni Bond Fund ETF (MUB)
This is a national muni bond exchange traded fund (ETF), so it is only tax-free for federal income taxes. The expense ratio is a low .25% and the fund holds over 375 different bond positions. 83% of the fund is invested in bonds rated AA or higher. The average duration of the fund is 7.5 years.
SPDR Barclays Short-Term Muni Bonds Fund ETF (SHM)
This is a national muni short term bond fund. It is shorter term and safer. The average duration of the fund is only 2.9 years and 100% of the bonds are rated AA or higher. The expense ratio is only .20%.
Keith Tufte
President
Longview Wealth Management, LLC.
http://www.longviewwealth.com
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