published Wednesday, June 20th, 2012

Personal Finance: Municipal bonds not always best pick

Chris Hopkins

We all hate paying taxes, so any investment that purports to offer relative safety and the promise of tax avoidance naturally strikes a chord.

Municipal bonds and bond funds often show up in investors' portfolios for those very reasons.

However, a careful assessment of the appropriateness and quality of these bonds is essential, perhaps more so today than at any time in recent memory. For most investors who are not in the highest tax bracket, these bonds are not the best choice and may actually add unnecessary risk.

Municipal bonds are older than the Renaissance; Italian city-states sold notes to raise revenue as early as the 12th century. In the United States, state and local governments issue bonds to pay for roads, sewers, hospitals, schools and virtually every other infrastructure or social service endeavor.

In order to encourage investors to purchase these bonds, the U.S. tax code generally exempts the interest income from federal taxation (with some exceptions).

Since the income is tax-free, issuers can sell the bonds at lower interest rates, resulting in reduced borrowing costs. For investors living within the jurisdiction of the issuer, income also typically is exempt from state and local taxation as well. Sounds great if you loathe paying taxes.

However, for most individuals, the impact of tax avoidance is insufficient to justify the lower return.

Take for example a couple whose marginal tax bracket is 25 percent (adjusted gross income less than $139,350). A typical 10-year AA-rated muni bond yields an average 2.35 percent. After adjusting for federal taxes, the same investor would need to get 3.13 percent from a taxable bond to enjoy the same after-tax return. The differential would be somewhat higher considering state income taxes where applicable, but still relatively small.

But that is not the only reason to think twice about municipals.

One should be highly reticent to extend maturities out to 10 years given the historically low level of rates today. This is especially true for investors who hold bond mutual funds or ETFs; the risk of capital loss over the next few years is likely to outweigh the after-tax income yield as interest rates begin to climb.

Furthermore, there is a heightened risk of default or distress for some types of municipals compared to historical norms as states and cities face increasing stress from weak revenue growth and unsustainable pension obligations. Moreover, certain types of bonds called "revenue bonds" are backed solely by the cash flow from a specific project (airport, power plant, etc.) and carry heightened risk of loss if the project does not meet expectations.

Meanwhile, the notion of "insurance" on these bonds is essentially anachronistic, as most of the private insurers are no longer in a financial position to back the bonds if substantial defaults do occur. Caveat emptor.

Municipal bonds can be attractive to investors in the highest tax brackets with access to competent research and oversight. For the average investor, however, it's hard to see much value, even if you hate paying taxes.

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