The Allure of Municipal Bonds
Municipal bonds have always been popular with
investors for one reason -- you earn interest income
without paying federal income taxes.
Interest rates on tax-exempt bonds vary depending
on the maturity date, the issuer, the purpose of the
issue, and prevailing market conditions. Over the past
four years, municipal bond yields have approximated 80
to 95% of the yields paid on U.S. Treasury securities
with similar maturities and 75% to 90% of the yields on
corporate bonds. Since municipal bond interest isn't
subject to federal income taxes, that means that for
someone in the 28% tax bracket, municipal bonds have
paid a higher after-tax return during the past four
years. (Past performance, however, is no guarantee of
future performance.) Treasury securities are
guaranteed as to the timely payment of principal and
interest. Corporate and municipal bonds have fixed
principal value and yield if held to maturity.
For taxpayers in a 15% tax bracket, municipal
bonds are probably still not very attractive. Nor
should they be used as IRA investments, since that
income is already tax deferred. But people in higher
tax brackets as well as children under 14 whose
investment income exceeds $1,200 may find municipal
bond investments attractive.
To help decide whether you should invest in tax-
exempt bonds, you need to compare the taxable
equivalent yield of a tax-exempt bond to the yield of a
similar taxable investment.
Municipal bonds have the same risk as other
bonds -- if interest rates rise, the price of your
bonds will decline and vice versa.
Types of bonds
Municipal bonds are debt issues of cities and
towns, states and territories counties, local public
housing authorities, water districts, school districts,
and similar governmental units. There are two types of
municipal bonds:
- General obligation bonds pledge the faith and
credit of the government that issues them, meaning that
the government stands ready to use its taxing authority
to ensure that the bonds and interest are paid.
- Revenue bonds are issued to finance a specific
project, with the revenues from that project being used
to pay the principal and interest. They are typically
used to finance airports, water systems, transit
systems, and sports stadiums. It is important to check
the viability of the project before investing.
All municipal bonds issued before August 8, 1986
remain fully tax-exempt, while the tax status of bonds
issued after that date varies depending on the type of
bond. Some municipal bonds are now fully taxable,
while the income from the others are subject to the
alternative minimum tax (AMT). There are three basic
ways to invest in municipal bonds:
- Individual bonds can be purchased with a minimum
face value of $5,000. You should purchase more than
one issue in order to provide adequate diversification.
The after-market for municipal bonds is not as
extensive as other bond markets, sometimes making it
difficult to sell before maturity.
- Unit trusts sell interests in a fixed portfolio
of municipal bonds, ensuring a constant yield on the
bonds. Since unit trusts sell on the open market,
however, the value of your shares will fluctuate in
response to changing market conditions. When the last
issue matures, the trust ends.
- Mutual funds also sell interests in a portfolio
of municipal bonds, but the portfolio changes as the
fund manager buys and sells bonds to respond to
changing market conditions. This means that the yield
will also fluctuate.
No matter how you decide to invest, it is
important to review the investment carefully. Check
the credit quality of the bonds, since you will
probably hold the bonds for ten years or longer.
Governments can have financial problems just like
companies, so it is important to invest in high-quality
issues.
Review the call provisions of the bond, so that
you are not surprised by a bond call. Find out whether
the bonds carry bond insurance. The insurance raises
the credit rating of the bond, but also reduces the
yield because there is less risk of default. Insurance
will not affect market risk.
Before investing in a unit trust or mutual fund,
examine all costs.
Tax reform has left municipal bonds in an elite
group of investments -- one of the few that exempt
income from taxes, making them an attractive investment
for many people.
