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Investing in Municipal Bonds

Investing in Municipal Bonds

You may want to consider municipal bonds as part of the fixed income portion of your investment portfolio. States, cities and other local authorities issue municipal bonds (munis) to fund their general activities or to fund a specific project. Their interest is exempt from federal income tax and may be free from state tax if the bonds are from your home state.

There are three issues to consider for municipal bonds:

  • Does the tax-free nature of the interest justify the usually lower rate?
  • What are the risks?
  • How can they be purchased?

Tax Implications

It is only logical that the interest rates on municipal bonds are generally lower than those of similar taxable bonds. To determine if munis make sense, you need to compare the after-tax yield of a similar taxable bond with the yield of the tax-free bond. If the tax-free bond yield is higher, then you may want to consider it. Here is a chart to help with the comparison.

Or you can use the following table:

Tax exempt yield
Equivalent taxable yields in these marginal tax brackets
15%
25%
28%
33%
35%
39.6%
3.0%
3.5
4.0 4.2 4.5
4.6
5.0
3.5%
4.1
4.7 4.9 5.3
5.4
5.8
4.0%
4.7
5.3 5.6 6.0
6.2
6.6
4.5%
5.3
6.0 6.3 6.8
6.9
7.5
5.0%
5.9
6.7 6.9 7.5
7.7
8.3
5.5%
6.5
7.3 7.6 8.3
8.5
9.1

The tax brackets are those in effect in 2014.

Remember, to get a true comparison, it is critical that the taxable and tax exempt bonds have similar maturity dates and similar quality ratings.

A 5% tax-free yield equates to a 7.7% taxable yield for someone in the 35% marginal tax bracket.

Risks

Like any investment, there are risks with owning municipal bonds. There can be defaults if the issuer does not pay the interest during the term of the bond or repay the principal on maturity. To guard against default, you should probably stay with the bonds that are highly rated by professional rating agencies like Moody's and Standard & Poors.

In addition, the value of the bonds can change as interest rates change. When interest rates rise, the market value of bonds (including municipal bonds) falls. The opposite holds true as well. If rates fall, the value will rise. The amount by which the value drops (or rises) is largely dependent on the maturity length of the bond. The longer the time until maturity, the greater the change in value as rates change.

Buying Municipal Bonds

Along with buying individual municipal bonds, you may want to consider investing in a municipal bond mutual fund. Most stockbrokers will want to sell at least $5000 of a single issue. With a municipal bond mutual fund, the minimum investment may be smaller and you get the services of the portfolio manager who selects and monitors the portfolio of bonds.

Summary

Municipal bonds have the usual risks of any fixed income investment. However, if your tax bracket is high enough and you stay with high quality bonds they can be an attractive addition to your portfolio.

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