Another Look at Munis

November 10, 2009
Michael Sheehan

Tax exemption is the foremost reason municipal bonds remain attractive to investors, which will become more rewarding if, as expected, the Obama administration raises taxes.

Municipal bonds weren’t able to escape last year’s market implosion, but buyers have rushed back in as the lower prices boosted yields. Year-to-date, muni-bond mutual funds have risen by an average of 14.4% as yields, moving in the opposite direction from prices, have dropped. But munis are still attractive for other reasons, say bond analysts.

The foremost reason is taxes. Municipal bond interest is free of federal income tax, as well as any state income tax if the bond is issued in the state you live in. With yields on 10-year AAA muni bonds about the same as the rate on 10-year Treasuries, an investor in the 28% tax bracket would enjoy a tax-equivalent yield on muni-bonds of about 1.5 percentage points higher than the taxable yield on the Treasury. Investors living in a high income tax state like New York or California would get an even bigger break on bonds issued in their home states. The tax-exempt feature is expected to be even more important if, as expected, the Obama administration raises taxes.

Since investing in a broad range of individual muni bonds takes a stash of $250,000 or more, according to bond experts, most investors opt for muni-bond mutual funds. Funds offer some protection from default by individual munis, but bond advisors suggest that you take a careful look at risk and expenses. Be leery of funds that trade in lower-rated bonds or charge high fees. Also, some muni bonds are subject to the alternative minimum tax. If you might be caught in the AMT net, you should read the fund’s prospectus to see if you may have to pay the AMT on some of the interest you earn.