Municipal bonds can add some pizazz to the yield of your fixed-income ladder, but, as usual, do-it-yourself investors should proceed with plenty of hesitation.
Municipal bonds are issued by local governments to help pay for a wide assortment of public projects such as building bridges, hospitals, schools and the like. For in-depth background on "munis," visit the Security Industries and Financial Markets Association's (SIFMA) Web site Investinginbonds.com.
The interest earned on most munis is exempt from federal income tax and sometimes from state and local taxes as well. That's what attracts a lot of investors. But munis are complicated and you should spend plenty of time exploring the territory before buying. For example, if you sell the bond and have a capital gain, the gain may be subject to federal tax.
Individual bonds have become a lot more accessible to people who manage their own portfolios. Plenty of Web sites, including SIFMA's, let you peruse bond listings. And when it comes to buying, some institutions, such as Fidelity and Vanguard, have $5,000 purchase minimums, which make the bonds affordable to a much wider group of investors.
Bonds and notes issued by the U.S. Treasury are considered a fail-safe investment because they're backed by the U.S. Government. But the picture is a bit less clear when it comes to bonds issued by municipalities. You can have credit risk with munis -- the issuing municipality may not be able to pay the interest or the principal. But the reality is that historically, munis have been extremely safe investments.
Give yourself a little added safety net by buying munis that are insured by a private insurance company -- it automatically gives the bond a AAA rating. Is it 100 percent foolproof? Maybe not, but how many investments can claim that status? Also, some advisers say you should stick with general obligation bonds versus revenue bonds because governments can use their taxing power to back general obligation bonds.
You may also want to consider limiting your municipal bond purchases to ones that state they're not subject to the Alternative Minimum Tax.
Jason Flurry, Certified Financial Planner and president of Legacy Partners Financial Group in Woodstock, Ga., suggests using insured municipal bonds in a ladder that could be comprised of a variety of bonds such as munis, Treasuries, government agencies and CDs.
"One could anchor the long end of a ladder with these and smooth out the thrills and spills of the short-term yield curve. We're looking at government agency notes in the 10- to 17-year range as a complement to the long (securities) and filling the gaps with some AA, or higher-rated corporate notes. All things considered, we can lock in a net yield of around 6.25 percent to 6.5 percent this way."
This may be a much longer ladder than many people are used to, especially if you only ladder CDs. Flurry says these long ladders are best for retirees who have enough money to live on but need to lock in an income stream that they won't outlive; one that will keep them ahead of taxes and inflation, and will supplement their Social Security or pension.
"We'll have an ultrashort-term area which is maybe a year or less, a short term of one to three years, and then an intermediate term which is three to maybe seven years," says Flurry.