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Thinking About Munis? Make Sure You're
Making Wise Picks
Municipal bonds have long been a safe haven for higher-income
investors looking for safety and greater tax efficiency. The
credit squeeze put the municipal bond market through its paces
like other competing markets this year, but it may be time to
take a second look at both municipal bonds and muni bond funds.
Let's start with a definition of what a municipal bond is. A
municipal bond, or muni, is a bond issued by a local government
or their agencies to raise funds for a host of reasons tied to
keeping the government going. The potential issuers may include
cities, counties, redevelopment agencies, water and sewer
projects, school districts, publicly owned airports, seaports
and other transportation entities. They pay for everything from
immediate government expenses to new roads and various public
projects. Municipal bonds come in two flavors — general obligation
bonds and revenue bonds. General obligation bonds are intended
to raise immediate capital to cover government expenses; revenue
bonds are the ones that fund infrastructure projects.
As an incentive for investors to buy these bonds, interest
income is often exempt from federal income tax as well as the
income tax of the state in which they are issued. Mutual funds
that invest in municipal bonds also offer the same tax
treatment.
This year has held lots of excitement for muni investors and
those who were hoping to be. The credit crunch sucker-punched
funding sources for public projects as well as private
investments — many municipalities ended up dropping certain
projects because investors weren't there to buy the paper and
other sources of financing had dried up as well.
Who's fled the muni market? Hedge funds, issuers of
structured notes and municipal bond mutual funds trying to keep
up with redemptions from tapped-out investors. Right now, the
best source of demand for munis is individuals, who can account
for only so much business. But in the absence of other buyers,
that's potentially good news for you.
Keep in mind that even during the Great Depression, no state
defaulted on its general-obligation bonds, and while some munis
have defaulted, overall, such defaults are very, very rare.
So where's the opportunity for you? Look at some of the
highly rated outstanding bonds. You'll find some amazing yields
that you certainly won't find in CDs and other investments. Even
though their prices have plunged, some municipals late last year
were offering long-term, tax-free yields of five percent and
above, which translate into the equivalent of nearly seven
percent for taxpayers in the 28 percent bracket and nearly eight
percent for someone in the top 35 percent bracket when the tax
exemption is considered.
That's a very nice return relative to U.S. Treasuries,
considered the safest investments of all. But before you buy,
here are some things to know and steps to follow.
Are munis right for you? The first call you make
shouldn't be to a broker. It should be to your tax professional
and your financial adviser. A CERTIFIED FINANCIAL PLANNER™
professional can take a look at your entire taxable investment
portfolio (there's no point in putting tax-exempt munis into
tax-exempt accounts like IRAs or 401(k)s) and determine whether
they're the right approach to take for your investments.
What munis are in trouble? There are some governments
who issued a hybrid muni known as a variable-rate demand note.
These were sold mainly to institutions with maturities of up to
30 years that were paying at rates reset as frequently as once a
day. During the crisis, the rates on these notes have shot up to
double-digit territory, putting the municipalities that issued
them under particular strain due to short-term interest rates
that can be reset as frequently as once a day.
Keep an eye peeled for the AMT. While most munis pay
interest that's free from federal income taxes, some may pay
rates that are subject to the alternative minimum tax, known as
the AMT. It's a little more complicated than we have space for
here, but this is absolutely why you need to talk to your tax
professional or financial planner before making a move into
munis.
Don't forget to ladder. "Laddering" is a
portfolio structuring term. To ladder bonds means that you are
buying them with maturities occurring at regular intervals, so
when they mature, you'll have money to reinvest at those same
regular intervals.
Watch those ratings. Yes, the main private investment
ratings firms — Moody's and Standard & Poor's among them —
have
been in the doghouse for rating many battered investments
highly, not just munis. But most municipals rated AA or AAA are
generally safe to consider. It's also important to check the
issuer's long-term ratings history. If they've been consistently
highly ranked over decades and the municipality has no financial
scandal (something that can be checked through news archives on
the Internet), that's another good way to research a bond issuer
before making a purchase.
January 2009 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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