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Municipal bonds

By David Luhman on Sat, 05/09/2009 - 23:35

Municipal bonds

Municipal bonds are good for high income people

Although investing in foreign bonds isn't a great idea for anyone, investing in municipal bonds may be a good idea for some people.

If you have a fairly high income, you should take a look into investing into municipal bonds. Almost all municipal bonds are exempt from federal income tax, and most municipal bonds issued in your state also are exempt from state income taxes.

However, only the interest income is exempt from taxation. If you sell a municipal bond, or bond fund, at a gain, you'll have to pay capital gains taxes.

If you're in the 28 percent marginal tax bracket, municipal bonds are probably worth a look. If you're in the 31 percent marginal tax bracket, municipal bonds are certainly worth investigating.

However, since municipal bonds are exempt from federal income tax, these bonds will offer a yield that is lower than the more creditworthy US Treasury bonds. To determine if investing in municipal bonds is right for you, you need to compare the after-tax yields of munis with taxable bonds of comparable credit quality.

How to tell if you should invest in municipal bonds

Suppose blue chip corporate bonds are yielding 10 percent, and municipal bonds yield only 8 percent. If you're in the 15 percent marginal tax bracket, the corporate bonds will provide a higher after-tax yield.

However, if you're in the 28 percent or higher bracket, the municipal bonds provide a higher after-tax return. And remember that municipal bond funds come in all different maturities including money market funds.

Never put municipal bonds in a retirement account

Notice that you should never invest in municipal bonds inside of a retirement account. Retirement accounts already provide tax sheltering, so go for the higher yield provided by something like a corporate bond instead of the lower municipal yield.

Also, if you're investing in municipal bonds, keep an eye on tax reform legislation. Tax reform packages offered by both Republicans and Democrats would end the tax exempt status for municipal bonds. If these tax reform packages became law, municipal bond prices will drop.

Don't invest in most double exempt muni bond funds

Finally, should you invest in a so-called double-exempt municipal bond fund? The answer is usually no.

These funds invest in municipal bonds issued by a single state. For example, California investors might want to invest in a California double-exempt fund that invests only in California municipal bonds.

This way, the interest income earned by the California investor is exempt from federal income tax and California state income tax. This makes the after-tax yield even better for a California investor.

Almost every state has double-exempt bond funds. Even states that have no state income tax for some reason have double-exempt bond funds.

However, most of these funds should be avoided. The problem with most of these funds is that their fees are too high. A typical double-exempt bond fund charges a sales load of 5 percent and has an expense ratio of well over 1 percent.

However, if you live in a big state with high tax rates like California or New York, you probably can find a bond fund that is both double-exempt for your state and has low costs. The Vanguard mutual fund family is usually the place to look for these kind of funds.

Insured municipal bonds

There are several levels of credit risk in municipal bonds. Conservative investors can invest in insured municipals where an insurance company will assume the local government's obligations if the local government goes bankrupt. This insurance comes at a price, generally in the form of reduced yield.

General obligation bonds

Uninsured general obligation municipal bonds aren't as safe as insured municipals, but they are generally good credit risks.

General obligation bonds are backed by the local government's full taxing authority. With GO bonds, the local government has the obligation to raise taxes to meet the debt payments.

Revenue bonds

Revenue bonds are another form of municipal bond. In this case the municipality doesn't guarantee that the local government will be liable for the debt.

Revenue bonds typically are issued to pay for new sewers, stadiums or airports. The water department or stadium collects usage fees, and these fees are used to pay off the debt. If the usage fees aren't sufficient to pay off the debt's obligations, the government isn't on the hook to make up the difference.

Revenue bonds for essential services like sewage are probably safer investments than bonds used to finance things like stadiums or convention centers.

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