Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

The Safe Haven of Municipal and Local Bonds

Bonds are recognized as an important element of a well-balanced portfolio. They provide an effective hedge during economic downturns and have established a reputation for being a conservative investment.

Nevertheless, the bond market is not without its risks. When the general levels of interest rates rise, for example, the values of existing bonds are lowered. However, the average bond portfolio’s performance has been considerably less volatile than that of a typical stock portfolio.

Within the bond market, there are numerous options. One very specialized choice that can be attractive for certain investors is the submarket for municipal and local bonds -- sometimes referred to as Munis.

Munis are debt that has been issued by states, cities, counties, local agencies, special districts, schools and even U.S. territories and possessions. The funds borrowed are used for many purposes, including the construction of schools, highways, housing, hospitals and other public projects. If you have voted, you may recall considering measures that authorized such borrowings.

Their signature feature is that the interest earned is generally exempt from federal income taxes. In some cases, the exemption even extends to state and local taxes as well. This is particularly true if the bond is issued by a governmental unit within the investor’s own state.

These tax exemptions are not fully assured for every bond. However, new investors can take comfort in the fact that it is not necessary to master the intricacies of the governing legislation and its various restrictions. Your investment advisor will be able to steer you to a variety of appropriate choices. Most importantly, she will show you tables from which you can determine if your after-tax return will be competitive with similarly-rated taxable bonds.

Some bonds contain call provisions which allow the issuer to retire part or all of the debt before maturity. Ask your advisor about this, as well, and if it affects anything you may be considering.

If you are subject to the alternative minimum tax, you should also consult with your tax attorney or accountant to confirm that any anticipated investment is, in fact, providing you with a tax-free benefit.

Most municipal bonds pay interest on a semi-annual basis. A small portion of the market, however, involves what is known as zero-coupon bonds. In this type of situation the initial investment is heavily discounted and all of the interest income is paid at maturity, along with the principal. U.S. savings bonds and the old war bonds are well-known examples of zero-coupon investments.

There are also convertible zero-coupon bonds available. These start out as zero-coupon bonds and then, after a period of time, they convert to interest-paying bonds. They often meet the needs of those saving for retirement. During their employed years, these investors can accumulate tax-free capital that will be available to them when they retire. Then, during their retirement, they can receive a tax-free income stream.

There are other specialized types of Munis as well, but your investment advisor should be able to determine if any would be appropriate for you.

In recent years, the municipal bond market has grown rapidly as states and communities have found it to be an effective way to finance needed projects. And at the same time, certain categories of investors have been increasingly attracted to the net returns available after taxes.

With the overall U.S. market surging into the trillions of dollars, it would seem that there would always be a degree of safety in numbers. However, some specific bonds may be thinly traded. This simply means that there may be relatively few investors involved. Such situations represent a risk you might not initially be aware of. Emerging credit problems, for example, could result in am unusually sharp drop in the market price. It would be advisable to be aware of the breadth of ownership for any issue you might consider.

Most long term studies covering the period after World War II indicate that defaults in the municipal bond market have amounted to 1% or less. However, these results tend to mask the fact that there have been brief periods in which defaults have risen significantly.

Problems in the municipal bond market have come in waves. The results suggest a strong correlation to the business cycle. The Great Depression, for example represented one of the worst periods. According to a University of Michigan study published in 1964, over 15% of the municipal debt outstanding in the early 1930’s went into default. Furthermore, no less than 80% of the dollar value of the defaulted bonds had been given the credit agencies’ highest rating as recently as 1929.

One way to reduce your risk would be to consider investing in a specialized mutual fund. You would not only be taking advantage of the professional day-to-day management available but you would also be achieving a greater degree of diversification. Fidelity Investments has several funds that offer a variety of choices. Another possibility might be the Elfun Tax Exempt Income fund.

The Investing Answer: Depending upon your tax situation, municipal bonds can offer the opportunity for higher returns without compromising the safety of your portfolio. And, as with all bond investments, you would be creating a predictable stream of income that would always be marketable, in the event you decide to sell before maturity.