Single-state muni funds have risks, however. When the economy slows, state and local tax revenues go down while some costs go up. As a result, some states will have more difficulty than others in paying interest to bondholders. “We have sold our single-state bond funds and put the money into funds holding bonds from around the U.S.,” says Dimitroff.
Lassus also prefers national muni funds to single-state funds. “I remember when Massachusetts ran into financial trouble and its municipal bonds got creamed,” she says. “The extra money you’d get, after tax, is not worth taking the risk that your state’s bonds will be downgraded and your single-state muni fund will lose value.” As seen in the John Smith example, an investor with a six-figure muni portfolio might give up only a few hundred dollars a year by putting money into a more diversified national bond fund.
A severe economic slowdown will make it difficult for some muni issuers to pay the promised interest to bondholders. Typically, though, “general obligation” munis will be safe because they’re backed by the full credit and taxing power of the issuing state or city. “Revenue” munis rely on money from a specific facility.
“Revenue bonds can be safe,” says McGregor, “if they’re backed by an essential service such as water, sewers, or public transportation. Nonessential revenue bonds are the ones that might face problems.” He lists bonds backed by airports, housing developments, parking lots, and sports stadiums among those that may be affected by a deep recession.
McGregor says investors should ask their brokers for details on individual munis before investing; muni funds reveal the ratings and the maturities of the bonds they hold. Among the muni funds managed by McGregor, Northern Tax-Exempt Fund (NOTEX) receives four stars from Morningstar and yields more than 4%. Lassus’ recommendations include Vanguard Intermediate-Term Tax-Exempt Fund (VWITX). It’s another four-star Morningstar fund and carries a 4%+ yield that you won’t have to share with the IRS.
This story originally appeared in the February 2009 issue of Black Enterprise magazine.