Are you looking for a potentially high-yielding, tax-free investment? A way to shelter some of your income? If so, municipal bonds-bonds issued by state, county, city and other government entities to fund various projects-could be an investment option.
“The primary reason people invest in municipal bonds is that the interest is not taxable by the federal government,” says John Markese, president of the Chicago-based American Association of Individual Investors.
“Also, the fully taxable equivalent yields, adjusted for the fact that you’re not being taxed, are relatively high. Municipal bonds are one of the least complicated tax shelters around for individual investors.”
But even though interest earned on municipal bonds is exempt from federal tax-and in most cases from state tax on bonds purchased by residents of the states the bonds were issued in (two exceptions are Illinois and Wisconsin, where only some in-state bonds are exempt)-investing in what those in the industry concede is an unregulated, hard-to-track market is not risk free.
Says Bob Davis, a partner at Chicago’s Fitzgerald, Davis & Associates, which trades and sells munis: “The muni bond market doesn’t have a quote system like the stock market. . . . and its true prices can fluctuate by a fair amount (on the same bond issue).”
Because there is no New York Stock Exchange equivalent for municipal bonds, because most bond issues are not regularly tracked and because prices can vary greatly, it is important for potential investors to understand the types of bonds available, how they can be purchased and the factors that influence bond performance.
According to “Life After CDs: A Practical Guide to Safe Investing” by certified financial planner J. Michael Martin (Dearborn Financial Publishing Inc. and Financial Advantage Inc., 1993), munis fall into one of two categories: general obligation bonds and revenue bonds.
General obligation bonds (GOs), writes Martin, are “backed by the full faith and credit of the issuing government.” That means that revenues are not tied to the performance of a particular project, Markese explains. Revenue bonds, on the other hand, rely on revenue from specific projects to pay interest and principal.
That’s why Martin, Markese and Davis agree that GOs are generally safer investments for individual investors.
Municipal bonds can be purchased through brokers, with investors either buying the bonds themselves or investing in mutual funds that hold the bonds. Markese says that almost every mutual fund family offers muni bond funds, and recommends that avenue of investing for most individuals.
But financial advisers also warn that people investing in a municipal bond fund should watch out for tax traps. That’s because many funds distribute their capital gains-profits realized from selling bonds for more than the price paid to buy them-to shareholders late in the year, often in December. And unlike the interest from munis, capital gains are taxable.
“Before investing, it’s wise to make a phone call to find out whether any intended distribution will be large enough to make it worth waiting before making an investment in a particular fund,” notes the Value Line Investment Survey in a current bulletin.
That’s a primer on purchasing munis. Now here are some tips from the experts for those seriously considering a municipal bond investment.
– Deal with a reputable broker, and get bids from more than one source. “If I were buying a muni bond-even now, as a professional (in the business)-I’d check with at least two different brokers to make sure I was getting a fair value,” says Davis. “And let the brokers know they have competition. It will help you get a fair quote.”
– Buy investment-grade-quality bonds. A bond’s rating from such organizations as Moody’s and Standard & Poor’s is one factor that has an impact on the interest rate a bond bears. Two sources for checking a bond’s rating are the Standard & Poor’s Municipal Handbook (212-208-1146), which has the credit quality of specific muni bonds, and the Stocks, Bonds, Bills and Inflation Yearbook published by Ibbotson Associates (800-758-3557).
Markese emphasizes the importance of ratings, stating that investors should buy the highest-rated, most liquid bonds available, especially when purchasing individual, as opposed to mutual fund, issues.
“I mean liquid in the sense that the bond is a large issue and has more than just local interest,” says Markese.
– Understand the call features of your bonds. According to “Life After CDs,” most municipal bonds are callable before maturity, which means the issuer can buy back the bonds after a specified date at a predetermined price.
Markese explains further that calls often occur when interest rates are declining, and notes that while investors receive refunds, “they may have to invest that money at lower rates” than the rates they thought they’d locked in for 10 or 20 years.
– “Ladder” the maturity dates of bonds in which you invest. If you have a total of $500,000 to invest, for example, Davis suggests buying a $100,000 bond that matures in 1998, another that matures in 1999, another that comes due in 2,000, and so on.
The reason for Davis’ suggestion is simple: If you invest all $500,000 in one bond that matures in 1999, you will have to reinvest that money at the interest rate in effect at the time of maturity. That interest rate could be a low one. By “laddering” your investment, there is the chance that interest rates will rise, and you’ll be able to reinvest at least part of your investment at higher interest rates.
– Don’t buy municipal bonds for IRA and Keogh plans. That’s the advice from “The Dean Witter Guide to Personal Investment” by Robert M. Gardiner (Dean Witter Financial Services, Inc., 1988; Signet, 1989). According to Gardiner, any bonds you buy for IRAs and Keoghs automatically enjoy tax-deferred status, thus eliminating the need for the tax-free feature of munis.
– Check the tax-free aspects of any muni bond you plan to buy with your accountant or financial adviser. Though municipal bonds, in general, are not subject to federal income taxes or, in some cases, state and city tax, not every muni has the same tax status, according to “Life After CDs.” That’s why it is important to consult with a professional who can determine if your investment will place you in an unfavorable tax situation.
