Municipal Bonds

MUNICIPAL BONDS CAN pay interest that’s exempt from federal taxes and, if you own bonds from your own state, maybe state and local taxes as well. Sound appealing? Before buying, you should calculate whether munis make sense given your tax bracket. We tackle that topic in the chapter devoted to investment math.

If munis will give you a higher tax-equivalent yield, you might be tempted to purchase a muni fund that focuses on bonds from your state, so the interest is exempt from state as well as federal taxes. But these funds come with added risk. It isn’t simply that you’re focusing on bonds from a single state. Also, single-state muni funds often own relatively long-term bonds, so they could get hit hard by rising interest rates.

Many munis are issued with 20- or 30-year maturities. The issuer can often call the issue after 10 years. That means investors get their money back early, but they could be giving up a bond with an attractive yield. Bond calls are less likely to occur if interest rates head higher from here, because municipalities will find it tough to replace the called bonds with lower-interest debt.

Don’t want to take so much interest-rate risk? Some national municipal bonds funds—those that buy bonds from around the country—focus on short-term or intermediate-term bonds. This may be a safer option, though you’ll pay a price in lower yields and less tax savings.

Vanguard Group has an impressive array of municipal bond mutual funds with low annual expenses, while BlackRock’s iShares offers a slew of municipal bond ETFs. Looking for a muni fund focused on your state’s bonds? If you live in a less populated state, you may have to cast a wider net, including checking out closed-end funds.

What about individual bonds? Those can be a decent bet if you buy and hold new issues, though you need to pay careful attention to credit quality. While municipal bonds were once viewed as almost risk-free, their reputation is now less sterling, thanks to defaults by Puerto Rico, Detroit and others.

What if you’re buying or selling existing individual bonds in the so-called secondary market? Unscrupulous brokers may charge huge markups when you buy and hit you with large markdowns when you sell. To arm yourself with information before trading, check out recent activity using the Municipal Securities Rulemaking Board’s EMMA (Electronic Municipal Market Access) system at MSRB.org. If the issue hasn’t traded recently, try EMMA’s price discovery tool, which allows you to see trading activity for bonds with similar characteristics.

Next: Mortgage Bonds

Previous: Savings Bonds

Article: Who Needs Munis?