- The Washington Times - Wednesday, March 23, 2005

Municipal bonds might seem best suited for the most conservative investors and retirees, but the tax benefits of these debt instruments should make them attractive to a much broader audience.

Municipal bonds — essentially the local equivalent of U.S. Treasuries — may not be the sexiest of assets, but they can be a real wealth builder for patient investors, particularly those living in states with high tax rates, such as California, Connecticut, Pennsylvania, New York and Massachusetts.

“It doesn’t matter your age so much as your tax bracket. I think even in the smaller tax brackets, munis can make a lot of sense,” said Hugh McGuirk, head of the municipal bond department at T. Rowe Price. “Fixed income wasn’t very popular in the late ‘90s, but if you look at returns over the last five years, municipal bonds have been one of the best-performing assets available.”

Building a portfolio of individual muni bonds would be a huge challenge for a small investor, so mutual funds are a wise choice, Mr. McGuirk and other specialists said. With funds offered by most of the major shops, a wide range of choices is available, focusing narrowly on single states and maturities, or more broadly on municipal debt due in varying stages across the nation.

In addition to diversification, the biggest advantage funds have over individual bonds is liquidity, said Robert R. Johnson, managing director of the CFA program division at the CFA Institute, a nonprofit group based in Charlottesville that certifies financial analysts. Many municipal bonds are thinly traded, and if investors wish to sell before maturity, they are likely to get back much less than they would for similarly rated, more actively traded bonds. That means if you do own individual bonds, unless you are a sophisticated investor, you should plan to hold them until maturity.

Because tax efficiency is their primary benefit, it doesn’t make a lot of sense to hold municipal bonds in a tax-exempt portfolio such as a 401(k) or an individual retirement account. However, there are several ways small investors can put munis to work, said Andrew Clark, bond analyst at fund tracker Lipper Inc.

For example, if you are saving for a child’s education, when he or she becomes a teenager and college is just a few years away, it might be wise to plunk those savings into a muni bond fund in which they can continue to earn interest, but not incur taxes.

“Why should your daughter be paying taxes at 16 on the $100,000, $200,000 or $300,000 you saved for her education? There’s no reason. At least tax defer some or all of that,” Mr. Clark said. The same strategy could be employed for a person who has been building up a retirement nest egg in a taxable account, he added.

“These really are the hidden gems of the bond fund world,” Mr. Clark said, noting that during the bull market for stocks, many investors neglected tax issues in planning their portfolios. “If stocks aren’t growing in triple digits, you should be thinking about taxes the whole time.”

Perhaps because the market for municipal bonds is more local in nature than it is for other types of fixed-income securities, muni bonds tend to attract the most individual investors. About two-thirds of the muni bond market is held by individuals, both by direct ownership and through mutual funds, said Michael Decker, senior vice president of the Bond Market Association. By comparison, individuals account for 15 percent of ownership of corporate bonds, Mr. Decker said.

The interest on most municipal bonds is exempt from federal income tax, and is usually exempt from local taxes. That means if you live in New Jersey and invest in bonds issued locally, you won’t pay any federal or state income taxes on the interest.

“You don’t have to be in the top tax bracket for that to make sense to you,” Mr. Decker said.

Adding to the attraction of municipal bonds is that they are usually quite highly rated, either on their own merits or because they are insured; the majority are rated AAA by the major credit agencies. In general, this means there’s very little likelihood of default; the default rate historically has been less than 0.5 percent, Mr. Decker said.

That’s not to say municipal bonds are risk-free, Mr. Johnson cautions.

“Yields on tax-exempt bonds are typically lower than those on taxable bonds, so investing in a tax-exempt fund makes sense only if you stand to save more in taxes than you would earn as additional income while invested in a taxable fund,” he said.

To determine whether a tax-exempt fund makes sense for you, compute the fund’s taxable equivalent yield, Mr. Johnson said. This figure enables you to take taxes into account when comparing your potential return on a tax-exempt fund with the potential return on a taxable fund. You must, however, compare a tax-exempt fund to a taxable fund of equivalent credit quality, or risk.


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