Why Smart Investors Are Buying Muni Bonds Now

Many financial advisers have soured on most types of bonds and bond funds because of low yields and forecasts of a recession. High-quality municipal bonds and bond funds are the exception. “Munis” not only help you limit your tax burden — but lately, they’re providing unusually attractive yields, and many of them are considered relatively safe. Munis are issued by state and local governments and related agencies to raise funds for general operations or special projects, such as schools and hospitals. Interest on munis is exempt from federal taxes. Munis issued in the state where an investor lives usually are exempt from state and local taxes as well.

To further explore why municipal bonds are especially appealing for taxable accounts right now, Bottom Line/Personal spoke with Jim Lynch, one of the foremost municipal bond investment consultants in the US…

What’s making munis more attractive than Treasuries? As the stock market plummeted in January, investors stampeded into US Treasury securities, whose interest is exempt from state and local taxes but not federal taxes.

Treasuries are regarded as ultrasafe because the chance of the federal government defaulting on its debt obligations is remote. This investor stampede drove Treasury prices higher and, as a result, drove yields much lower.

Suddenly the yields on high-quality muni bonds began to look better and better in comparison, especially for investors in higher tax brackets and those living in states with relatively high taxes who are looking for safe investments amid the stock market turmoil.

Example of relative rates: A typical top-rated two-year municipal bond’s yield recently was 2.4%, compared with 2.1% for a two-year Treasury. If you’re in the highest federal tax bracket (35%), your taxable-equivalent yield from the muni is 3.7%, reflecting the fact that the muni interest is exempt from federal tax. If you’re in the 28% bracket, your taxable-equivalent yield on the muni is 3.3%.

To determine whether you should invest in a muni versus a Treasury or a corporate bond, calculate the effective yield of the muni bond or bond fund. First, determine your income tax rate — talk to your accountant or go to www.irs.gov and search for “Federal Tax Rate Schedules.” Next, figure out the taxable-equivalent yield of the muni. Use the on-line calculator at www.cnnmoney.com/taxyield or the taxable-equivalent yield function at www.morningstar.com/centers/bonds.html (click on “Bond Calculator”).

As the value of real estate falls and the economy weakens, cities and towns may collect less in taxes. Isn’t there a growing danger that they will default on their bonds?

Municipal defaults are very rare even during recessions. Only about 0.3% of investment-grade munis default each year, on average, compared with 2.1% of investment-grade corporate bonds. However, with our stumbling economy, my current recommendation is very conservative. Stick with AAA- or AA-rated muni bonds with maturities of two years or less — or funds that specialize in these types of bonds.

The bond insurance companies that back munis have run into enormous financial problems recently. How much riskier does that make munis?

Bond insurers are little known outside Wall Street, but they play an important role behind the scenes to provide guarantees for issuers of relatively risky municipal debt. For example, a city that issues a bond can make the bond more attractive to buyers by insuring it. If the city defaults on the bond, the insurer steps in to pay investors.

Although the recent financial problems have hurt some munis backed by these insurers, you don’t have to worry if you stick with highly rated munis (which typically don’t need insurance) and funds that invest in them.

What about the outlook for interest rates? How will that affect munis?

If rates rise — and I expect that they will — the value of long-term bonds will probably fall, so if you need to sell such a bond before maturity, you may get a lower price than you paid. That is why I recommend owning bonds with maturities of one to two years, which are much less affected by rising rates than bonds with longer maturities are.

What if you are subject to the Alternative Minimum Tax (AMT)? Doesn’t that negate the tax-free status of some munis?

In some cases, yes. For example, interest from bonds used to finance “private activities” that benefit the public, such as building an airport terminal, is subject to the AMT. Private-activity bonds account for less than 10% of all muni issuances annually, but they are popular because they offer slightly higher yields.

Tell your broker to avoid buying bonds for you that are subject to the AMT. Or invest only in AMT-free muni bond funds, which most large fund companies offer.

Is it better to invest in munis issued in your state of residence so that you can avoid state and local taxes as well as federal taxes?

It’s better to diversify — never put more than 40% of your muni investments in your home state. Reason: If your state’s economy declines, the value of your muni bonds could drop. You don’t want to have to take a loss if you need to sell before prices recover or bonds mature. Ask your broker which muni bonds in other states offer you the best value, or invest in a multistate municipal bond fund.

The US Supreme Court is expected to rule on whether it is constitutional for states to grant tax exemptions for their own municipal bonds while not granting them to munis from other states. How could that affect munis?

It seems unlikely that the Court will rule against the current practice, but if it does, munis would suffer — especially if states have to drop their state tax exemptions, making muni bonds less attractive to investors in those states.

How can investors decide whether to invest in individual muni bonds or funds?

Muni bonds are typically bought in denominations of $5,000, but to get adequate diversification, you need to buy in much larger quantities — a total of at least $50,000 worth. If you don’t have that much to invest, consider muni bond funds.

If you have more than $50,000 to invest, it makes sense to buy individual muni bonds directly through your full-service or discount brokerage firm. Advantages…