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The Allure of Municipal Bonds


Adam Starchild

Municipal bonds have always been popular with investors for one reason -- you earn interest income without paying federal income taxes.

Interest rates on tax-exempt bonds vary depending on the maturity date, the issuer, the purpose of the issue, and prevailing market conditions. Over the past four years, municipal bond yields have approximated 80 to 95% of the yields paid on U.S. Treasury securities with similar maturities and 75% to 90% of the yields on corporate bonds. Since municipal bond interest isn't subject to federal income taxes, that means that for someone in the 28% tax bracket, municipal bonds have paid a higher after-tax return during the past four years. (Past performance, however, is no guarantee of future performance.) Treasury securities are guaranteed as to the timely payment of principal and interest. Corporate and municipal bonds have fixed principal value and yield if held to maturity.

For taxpayers in a 15% tax bracket, municipal bonds are probably still not very attractive. Nor should they be used as IRA investments, since that income is already tax deferred. But people in higher tax brackets as well as children under 14 whose investment income exceeds $1,200 may find municipal bond investments attractive.

To help decide whether you should invest in tax-exempt bonds, you need to compare the taxable equivalent yield of a tax- exempt bond to the yield of a similar taxable investment.

Municipal bonds have the same risk as other bonds -- if interest rates rise, the price of your bonds will decline and vice versa.

Types of bonds

Municipal bonds are debt issues of cities and towns, states and territories counties, local public housing authorities, water districts, school districts, and similar governmental units. There are two types of municipal bonds:

  • General obligation bonds pledge the faith and credit of the government that issues them, meaning that the government stands ready to use its taxing authority to ensure that the bonds and interest are paid.
  • Revenue bonds are issued to finance a specific project, with the revenues from that project being used to pay the principal and interest. They are typically used to finance airports, water systems, transit systems, and sports stadiums. It is important to check the viability of the project before investing.

All municipal bonds issued before August 8, 1986 remain fully tax-exempt, while the tax status of bonds issued after that date varies depending on the type of bond. Some municipal bonds are now fully taxable, while the income from the others are subject to the alternative minimum tax (AMT). There are three basic ways to invest in municipal bonds:

  • Individual bonds can be purchased with a minimum face value of $5,000. You should purchase more than one issue in order to provide adequate diversification. The after-market for municipal bonds is not as extensive as other bond markets, sometimes making it difficult to sell before maturity.
  • Unit trusts sell interests in a fixed portfolio of municipal bonds, ensuring a constant yield on the bonds. Since unit trusts sell on the open market, however, the value of your shares will fluctuate in response to changing market conditions. When the last issue matures, the trust ends.
  • Mutual funds also sell interests in a portfolio of municipal bonds, but the portfolio changes as the fund manager buys and sells bonds to respond to changing market conditions. This means that the yield will also fluctuate.

No matter how you decide to invest, it is important to review the investment carefully. Check the credit quality of the bonds, since you will probably hold the bonds for ten years or longer. Governments can have financial problems just like companies, so it is important to invest in high-quality issues.

Review the call provisions of the bond, so that you are not surprised by a bond call. Find out whether the bonds carry bond insurance. The insurance raises the credit rating of the bond, but also reduces the yield because there is less risk of default. Insurance will not affect market risk.

Before investing in a unit trust or mutual fund, examine all costs.

Tax reform has left municipal bonds in an elite group of investments -- one of the few that exempt income from taxes, making them an attractive investment for many people.

About the Author
For twenty years Adam Starchild has been writing books about these subjects, and they are published by a variety of publishers. They are available in many bookstores or public libraries.

For more information on asset protection, see Asset Protection & Becoming Judgment Proof.

Copyright © 1995 by Adam Starchild
The Investor's Library has reprinted this copyrighted article with the permission of the author.

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