Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Municipal bonds

Dear Dr. Don,
Are municipal bonds priced to yield 4.75 percent with 28 years until maturity a good investment for a 70-year-old in the 28-31 percent federal income tax bracket?
Charles Coupon

Dear Charles,
The interest income on municipal bonds is exempt from federal income taxes, and is typically exempt from state and local taxes to residents of the state where the issuing governments are located. (That's not true for all 50 states.)

The Bond Market Association provides a listing showing each state's income tax provisions for municipal bonds. When in doubt, talk to your tax professional before investing in municipal bonds.

That's especially true if you may be subject to the alternative minimum tax (AMT) since the interest on some municipal bonds is subject to the AMT.

The longer a bond's maturity, the more volatile its price is to changes in interest rates. The bond's ability to increase in price is mitigated by the fact that most long-term municipal bonds have call provisions that allow the issuing governmental entity to redeem the bonds prior to their stated maturity.

So if interest rates continue lower, these bonds could be called away from you. (Callable municipal bonds are typically protected from calls during the first seven to 10 years, and, if called, may pay investors a small premium in addition to the face value of the bond.)

If interest rates trend higher, then the bond isn't called and you're holding an investment that has declined in value.

One long-term municipal bond shouldn't be the backbone of your portfolio, regardless of your age, tax bracket, or the size of your portfolio.

Creating a laddered portfolio where you are buying short and intermediate maturities as well will keep you from making large interest rate bets on a single maturity.

This Bankrate feature will give you more information about laddering a bond portfolio.

-- Posted: Oct. 4, 2001