investing

'Extension' bond ladder makes sense now

Don TaylorQuestionDear Dr. Don,
Many stockholders fled to munis after the crisis or even before in some circumstances. Do you think there may be a municipal bond crisis soon?

Is it safe to buy municipal bonds that are triple A or double A, and free of state and federal income taxes? I would look at short-term and long-term maturities and ladder the money. What about corporate bonds? McDonald's, GE, Coca-Cola? Are they safer to invest in these days?
-- Maryanne Muni

AnswerDear Maryanne,
The typical retail investor doesn't make a good do-it-yourself bond investor when investing in individual issues. That's especially true for investors buying individual municipal and corporate issues. If you're not working with a financial adviser, a no-load bond mutual fund would provide professional management, and you can find one with low annual fees and expenses.

It's hard to know how the aftershocks of the recession -- combined with the increased demands on state and local government budgets -- will play out in terms of the financial integrity of the municipal bond market.

Counting on today's high credit rating to protect you from future bad news, however, isn't a viable strategy when it comes to investing in municipals. You need to keep your finger on the pulse of the issuer and monitor its financial health on a regular basis.

The taxable equivalent yield, or TEY, on municipals makes them look attractive when compared to Treasuries, but it's critical to remember that the two securities don't have the same risk. Part of the yield differential comes from the muni's increased risk. Bankrate's "Tax equivalent yield calculator" will calculate the TEY on a municipal bond.

Are corporate bonds the answer? In early August, IBM issued a three-year note with a 1 percent coupon. Corporate treasurers are lining up to issue debt at historically low rates. Do you really want to be the one buying in at these low yields?

A bond ladder gets you around the investment timing issue, at least when reinvesting the maturing rungs of the ladder. But if you build the ladder in today's low-rate environment, you should consider making it an "extension ladder." This approach allows you to keep the maturities short in funding the initial ladder, but extend out to longer maturities as the original rungs of the ladder mature. For example, you build a five-year ladder today, but gradually extend out to a 10-year horizon over the next several years.

Do you want to see the big (financial) picture? Get Bankrate's major financial stories of the week delivered to your inbox every Friday.

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