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.,â€ 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,â€ 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.â€ 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 obligationâ€ munis will be safe because they’re backed by the full credit and taxing power of the issuing state or city. “Revenueâ€ munis rely on money from a specific facility.
“Revenue bonds can be safe,â€ 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.â€ 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.