Maturity Issues
“Among individual munis, the best buys now appear to be those maturing in 10 to 15 years,†says McGregor. “You can earn 4.5%, even 5%, with high-quality bonds with those maturities.â€
Shorter-term bonds pay lower yields (around 3% on five-year munis now) but they will outperform long-term issues if interest rates rise in the future. “We prefer short- and intermediate-term munis,†says Marilyn Capelli Dimitroff of Capelli Financial Services in Bloomfield Hills, Michigan, “because they will hold their value better than long-term issues if interest rates rise. We look at bonds as ‘air bags’ for your portfolio: They provide safety, so we’re willing to accept a lower yield in return for lower risk.â€
Regardless of a bond’s maturity, McGregor suggests buying top-rated (AAA or AA), non-callable bonds. That is, avoid bonds that permit the issuer to buy them back if interest rates fall, in which case you’d have to reinvest at lower yields.
Genevia Gee Fulbright, chairman and COO of Fulbright & Fulbright, and her husband, Edward, who is the chairman and CEO of Fulbright Financial Consulting, in Durham, North Carolina, often recommend individual municipal bonds or municipal bond mutual funds to clients who are in high tax brackets. But the recommendation always comes with a warning. “Some cities and counties are having financial challenges. They may be unable to find buyers for their newly issued bonds or may not be able to issue new bonds. This may lead to opportunities for investors–higher yields,†says Fulbright. “But you must be cautious when you invest, so do your homework first.â€
Local Versus National
Choosing the right muni can be difficult. Just because munis are called “tax-exempt†bonds doesn’t mean that the interest is completely tax-free. You might avoid federal income tax but owe state income tax.
Suppose, for example, John Smith lives in California and owes state income tax of 9.3%. He invests $100,000 in a bond fund yielding 4% so he receives $4,000 in annual income from the fund. Although John owes nothing to the IRS, he’ll owe California $372 (or 9.3% x $4,000). After paying that tax, John’s after-tax income is $3,628, which is actually a 3.628% yield on his $100,000 bond portfolio. (John’s true yield might be slightly higher if the state income tax he pays to California is deductible on his federal income tax return.)
“You generally can avoid state and even local income tax by buying munis issued within your state,†says McGregor. Thus, John might escape paying any tax on his muni bond interest by buying individual munis issued in California or a bond fund that holds only California issues. So-called “single-state†muni funds are available to investors in many states with high income tax rates. The top 11 with Standard & Poor’s “AAA†rating are Delaware, Florida, Georgia, Indiana, Iowa, Maryland, Minnesota, Missouri, North Carolina, Utah, and Virginia.