Normally, municipal bonds are good deals for investors in high tax brackets, but they’re not necessarily worthwhile for people with moderate incomes. But, of course, these are not normal times. “Today, municipal bonds might be good for all investors,” says Tim McGregor, director of municipal fixed income at Northern Trust Corp. based in Chicago, observing that the forces of economic crisis have turned “munis” into an attractive safe haven.
McGregor makes sense, considering that if you invest in 10-year Treasury bonds today, you might receive a yield of between 3% and 3.5%. Assuming you’re in the highest federal income tax bracket, paying 35% to the Internal Revenue Service, you’d net a little more than 2%, after tax. In a 25% tax bracket, you’d wind up with about 2.4% to spend or reinvest. But compare those yields to a top-rated 10-year municipal bond. According to Bloomberg.com, you’d receive more than 4%—and you’d owe nothing to the IRS because muni bond interest is exempt from federal income tax. Therefore, you’d have almost twice as much after-tax income from munis compared with Treasuries.
Municipal bonds, of course, are a way for cities, counties, and states to raise funds for projects and other operations. Governments issue bonds as a way to borrow from the public with a promise to pay back (with interest) after a period as short as a few months or as long as 40 years. Munis have historically paid less interest than taxable bonds, but according to McGregor, that’s now changing. “First, virtually all types of investments suffered in 2008, so investors put their money in U.S. Treasury issues, which are considered a safe haven. Greater demand pushed up the price of Treasuries, and higher bond prices mean lower yields for investors.” Secondly, notes McGregor, “many hedge funds had large positions in municipal bonds. Those funds had to raise money to repay debt in the financial crisis, so they sold their munis to raise cash.” Just as strong demand for Treasuries lowered yields there, increased sales of municipal bonds lowered prices and therefore raised yields.
Bonds or Bond Funds?
Munis may not yield more than Treasuries for much longer. If you think this is a good time to invest for high tax-exempt income, you can buy individual bonds or choose among many municipal bond funds. Buying individual bonds gives you more control over your portfolio and probably will deliver a return of principal when each bond matures. Buying through a fund gives you diversification, which reduces your risks. “If you’re buying bond funds, costs are critical,” says Diahann W. Lassus, CFP, CPA/PFS of Lassus Wherley, a wealth management firm in New Providence, New Jersey. According to fund tracker Morningstar, the average municipal bond fund yields—a little more than 4% now–and charges investors about 1% a year. If you can find a fund with an expense ratio that’s much lower than average, you’ll probably increase your long-term return.