Getting More for Your Muni

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.

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.”

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.”

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.”

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.

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.