Looking for some tax-free income? Municipal bonds may be an attractive option.
Municipal bonds -- also known as "munis" -- are essentially loans to cities, counties, school districts, public utilities and other governmental entities for use in public projects.
State and local governments use the money to support schools, highways, hospitals, housing and other important public projects that affect our daily lives. By investing in municipal bonds, you're investing in your community.
In turn, the issuer promises to pay you a specified amount of interest -- usually paid twice a year -- until the bond reaches maturity, at which point your initial investment is returned to you.
But the real appeal is the tax-free income.
"Municipal bonds offer a great opportunity to add some safety and income to your portfolio. The appeal is reliable, tax-free income, simple as that," says Rick Ashburn, chief investment officer for Creekside Partners, a financial and investment advising firm.
The interest income from a municipal bond is generally exempt from federal, state and local income taxes, and the interest rate is fixed over the life of the bond. That's good news for investors if interest rates drop; you'll be earning higher than the average. If interest rates rise, though, you still will be paid the lower fixed rate, so it's best to invest short term.
"We caution investors to keep maturities less than seven years," Ashburn says. "The eventual return of inflation and interest rates to more normal levels will badly erode the value of longer-term bonds."
*Are Munis for You?
Investors need to know their marginal tax rates and do the math to determine whether municipal bonds are a better choice than regular bonds.
"Investors with high marginal tax rates generally benefit the most from not having to pay federal income tax on the interest received from bonds," says Johan Grahs, vice president of Porter, White & Co., an investment banking and advisory firm. "The net benefit is directly related to your marginal tax rate."
For example, an investor with a combined state and federal tax bracket of 37 percent will lose 37 percent of any taxable bond yield. Therefore, a 5 percent taxable bond produces 3.15 percent after tax, according to Ashburn.
"If the income from a municipal bond exceeds the after-tax income from a regular bond, then you buy the muni," Ashburn says. "If a municipal bond can be bought yielding 4 percent, then the muni is a better deal."
Cost is another concern.
"Municipal bonds are relatively expensive to buy and sell in smaller lots, such as less than $100,000," Grahs says.
*What's the Risk?
Municipal bonds generally are seen as a conservative investment, but they are not without risk.
"Munis are safe if carefully selected. The risk of municipal bonds is the same risk all fixed investors face -- credit and duration," Ashburn says. "The longer the term of the bond the more risk you take that increases in inflation will erode your purchasing power. Never, ever buy 25-plus-year bonds. You take all the risk, and if rates stay low and your bond value has raised, the issuer calls the bonds away from you in 10 years, leaving you to reinvest in a lower-rate environment."
Investors also run the risk of nonpayment when the bond reaches maturity.
"Municipal bonds are generally less risky than stocks but often have some form of credit exposure. Most municipal bonds today are revenue bonds, and the revenue available to service the bonds is an important consideration," Grahs says.
"For most municipal bonds, the risk of nonpayment is vanishingly small," Ashburn says. "We consider voter-approved general obligation bonds to be 'money good' under all scenarios, but stay away from bonds that aren't voter-authorized or payable from essential utility services."
Quasi-municipal bonds -- such as those issued by hospitals, nursing homes, port facilities, pollution control facilities and low-income housing -- run a high risk of nonpayment, Ashburn says. However, bonds that are voter-approved general obligations of the issuer and bonds payable from essential utility services -- such as water, wastewater and electricity -- tend to be highly secure.
"They have historically paid even in dire times, such as depressions and bankruptcies," Ashburn says.
Adding municipal bonds to a well-rounded portfolio is the smartest bet.
"Getting well-diversified exposure to municipal bonds through a mutual fund should always be part of the consideration. It generally offers better liquidity, in addition to diversification," Grahs says.