A Less Taxing Way To Invest

The yields on municipal bond funds are tempting -- and tax exempt, too

Investors looking to increase their portfolio’s yield without holding junk bonds might want to take a look at long-term bond funds. According to mutual fund research firm Morningstar, long-term bond funds were yielding a respectable, if not dazzling, 4.5% as recently as September.

There is a catch, though. If you hold these funds in a taxable account as opposed to a tax-deferred retirement plan, its yields must be shared with Uncle Sam. In a 28% tax bracket (taxable income over $70,350 on a joint return in 2004), for example, a 4.5% yield would shrink to a mere 3.24%. Tax payers in a higher bracket would net even less after taxes.

The solution? Consider municipal bond funds, which hold tax-exempt bonds issued by state and local governments. The interest on these bonds generally won’t be subject to income tax and this tax shelter is passed on to mutual fund investors. Long-term muni funds recently paid a 3.9% yield, which would put high-bracket investors ahead after taxes. “The case for buying municipal bond funds is pretty favorable,” says Scott Berry, a senior analyst at Morningstar. “Given where yields are now, there’s no reason to choose taxable bond funds if you’re in a high tax bracket.”

What’s more, municipal bond funds might be a good choice if the country is indeed entering a period where interest rates head north, as many analysts expect. “Municipal bonds may hold up better than other bonds as rates rise,” says Michael Tankersley, a certified financial planner with Investment Management Advisors in Birmingham, Alabama. “The overall economy is rebounding and the states are doing well. This is good news for muni bonds.” With state and local tax revenues on the rise, it’s more likely that municipal bond issuers will fulfill their promises to investors.

Assuming you find municipal bond funds appealing, you have several decisions to make. First, you must choose among long-, medium-, and short-term muni funds. “Yields are higher on long-term funds, and long-term returns will likely be better,” says Berry. “It’s true that you could see some volatility in long-term funds over the next year or two if interest rates rise, but long-term investors may be best served in long-term funds.”

Berry’s picks include Fidelity Spartan Municipal Income (FHIGX), Franklin Federal Tax-Free Income A (FKTIX), Vanguard High-Yield Tax-Exempt (VWAHX), and Vanguard Long-Term Tax-Exempt (VWLTX).

Stephen Overstreet, a certified financial planner with Financial Planning Offices in Winter Springs, Florida, prefers to avoid the volatility of long-term funds. “You shouldn’t invest solely for high yields,” he says. “You should be more concerned with total returns.”

Long-term bond funds are likely to lose value when interest rates rise, therefore the principal you lose might outweigh the extra yield you receive with a long-term muni fund. Intermediate- and short-term muni funds, on the other hand, won’t go down as much in a rising interest rate environment. “In particular, I recommend Vanguard Intermediate-Term Tax-Exempt (VWITX) and Vanguard Limited-Term Tax-Exempt (VMLTX) funds to clients. These funds have low expenses so they can pay more to investors. They

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