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Should you add ‘munis’ to investment portfolio?

POSTED: October 29, 2009 6:07 p.m.

It’s election season. Although you won’t be selecting either a new president or a new Congress, you may well have the opportunity to vote on something that can affect your city or state: municipal bonds. However, just because you vote to give your state or local government permission to issue municipal bonds doesn’t mean you have to invest in them. But should you?

Before you can answer that question, you need to know what municipal bonds are and how they work. General obligation bonds are backed by property taxes and finance projects from cities, counties, school districts and states. Revenue bonds are backed by a specific revenue source and finance hospitals, utilities, airports, affordable housing and other public works. So when you invest in a revenue bond, you are being somewhat civic-minded, although you aren’t confined to bonds issued by your city or state.

You can get other tangible benefits from investing in municipal bonds, or “munis.” First, you’ll receive regular interest payments. Just as importantly, these payments typically are exempt from federal income taxes — and possibly state and local income taxes as well. Keep in mind, however, that they may be subject to the alternative minimum tax. Consequently, if you’re in an upper tax bracket, you may be especially interested in munis.

Still, before investing in a muni, you’ll want to determine its yield. Basically, a bond’s yield is the rate of return it promises at any given price; when a bond’s price rises, its yield usually falls, and vice versa. The longer the time to a bond’s maturity, the greater its interest rate risk. To compare the yield of a tax-free muni to that of a taxable bond, you must calculate its tax-equivalent yield, which is based on the muni’s interest rate and your individual tax bracket. For example, let's say you are considering a tax-free muni that pays 4 percent interest, and you’re in the 28 percent tax bracket. To determine the bond's tax-equivalent yield, subtract your tax rate (.28) from 1, giving you .72. Then divide the bond's rate, or .4, by .72, giving you 5.5 percent. This means you would need to find a taxable bond that pays at least 5.5 percent to equal the yield of a tax-free muni paying 4 percent.

Even if you’ve determined that a tax-free muni’s yield compares favorably to that of a taxable bond, you need to assess some of the potential risks of owning munis. For one thing, municipalities are clearly not exempt from the effects of the long and harsh recession we’ve experienced.

Consequently, some projects funded by munis may have trouble generating the revenue needed to repay the bonds’ investors.

Another potential issue to consider with munis is their liquidity. Some states, such as New York and California, issue a great many bonds, which are traded regularly. But some municipalities operate in more illiquid markets, so if you buy a muni from one of these issuers, you may need to hold it until it matures.

Also, munis are traded “over the counter” rather than on an exchange, so it can sometimes be difficult to get a price quote for your bond, not to mention a buyer. These liquidity issues may not matter to you, however, if you intend to hold your bond until maturity, collecting regular interest payments along the way and eventually receiving your principal back. There is also credit risk when investing in bonds, where if the issuer defaults you could potentially lose all of your principal.

In any case, as long as you’ve done your research and gotten help from a qualified financial professional, you may find that municipal bonds can benefit you — so give them some thought.

Frank Bevenour is the Edward Jones representative in Rincon.

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