|
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%
|
|
3.0%
|
3.5
|
4.0 |
4.2 |
4.5 |
4.6
|
|
3.5%
|
4.1
|
4.7 |
4.9 |
5.3 |
5.4
|
|
4.0%
|
4.7
|
5.3 |
5.6 |
6.0 |
6.2
|
|
4.5%
|
5.3
|
6.0 |
6.3 |
6.8 |
6.9
|
|
5.0%
|
5.9
|
6.7 |
6.9 |
7.5 |
7.7
|
|
5.5%
|
6.5
|
7.3 |
7.6 |
8.3 |
8.5
|
The tax brackets are
those in effect in 2012.
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.
|
