Do Your Homework When Buying Muni Bonds

Physician's Money Digest, October 2005, Volume 12, Issue 14

Wall Street Journal

As predicted, interest ratesare beginning to inchupward. And while it'sunlikely they will explodethrough the roofin the near future, this rise should be asignal to take a closer look at bonds,particularly municipal (muni) bonds,according to the .When compared with US Treasurybonds, or Treasuries, the after-taxyields of these investment vehicles arevery attractive. The first step, however,is to decide if muni bonds are theright vehicle for you.

Multilevel Tax Breaks

The interest on muni bonds is generallyexempt from federal incometax. As a result, physicians who canexpect to be in a federal income taxbracket of 28% or higher could realizegreater income from munis than fromeither Treasuries or highly-rated corporatebonds. Similarly, if you live in ahigh-tax state, such as New York orCalifornia, keep in mind that yourmuni bonds are exempt from state andlocal income taxes.

In addition, muni bonds are a goodinvestment if you place a high priorityon capital preservation. That's becausemunis, also called general obligationbonds, are backed by tax revenue,making them a low risk for default.

Investing Strategies

Wall Street Journal

The next consideration is whetherto purchase individual muni bonds ormuni bond mutual funds. Either can bepurchased through a broker, butaccording to the ,the choice of which to purchasedepends largely on how much moneyyou have to invest.

It takes approximately $150,000 todiversify adequately when purchasingindividual muni bonds. If you haveless than $150,000 to invest, you'rebetter off purchasing muni bond mutualfunds, such as the Vanguard Intermediate-Term Tax-Exempt Fund. Otherparticularly attractive muni bondsinclude Chattanooga, Tenn, GeneralObligation Bonds and Houston, Tex,Independent School District Bonds.

As with any good investment strategy,you must diversify your holdings bypurchasing bonds that have varyingmaturity dates, up to a maximum of 10years. You should also own a 3 to 1mix of uninsured-insured bonds, butthe ratio can be as high as 2 to 1 in favorof insured bonds if you are an especiallyrisk-averse physician-investor.

On the other side of the coin, owningindividual muni bonds affords youmore control and flexibility whileavoiding management fees. Individualmuni bonds also lock in a yield, whereasfunds can rise and fall based on thefund manager's decisions.

Start with individual muni bondsthat have maturity dates of 10 years orless. Then, as interest rates rise andbonds mature, replace the long-termbonds with new, shorter-term bondsthat offer higher yields. This strategy isparticularly effective as you begin tonear retirement and expect to be in a28% or lower tax bracket.

Beware Hidden Pitfalls

Research Recommendations

An article in cautions that even muni bondshave some hidden tax pitfalls. Forexample, if you purchase munis issuedby a state or local government otherthan the state in which you reside, youare generally required to pay stateincome tax on the interest income.

Research Recommendations

A second pitfall is investing in privateactivity bonds, such as those usedto finance nongovernmental functions.The income earned from these bonds isconsidered an adjustment item for thepurposes of computing your alternativeminimum tax obligation and couldresult in a higher tax bill. As a result,the articlesuggests keeping this type of investmentto a minimum.

Moreover, if interest rates declineafter you purchase a muni bond, thevalue of the bond will increase. If yousell the bond, however, the profit istaxed as a capital gain. To avoid thispitfall, consider a two-pronged approach:Hold on to muni bonds thathave increased in value and sell munibonds whose value has declined orremained the same.

An Investor's Guide to Municipal

Bonds

Before purchasing muni bonds,make sure they are the right investmentvehicles for your needs. For moreinformation, contact the Bond MarketAssociation (646-637-9200; www.investinginbonds.com) to obtain a copyof .