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Municipal bonds: Investing pros and cons

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Municipal bonds represent an attractive investment for individuals looking for assets that provide tax-advantaged income.

Interest payments from muni bonds aren't subject to federal taxes. If the bonds are issued by the state in which the investor resides, they're free of state taxes. And if they're issued by the city in which the investor resides, they're free of city taxes.

"For clients in high tax brackets, munis can be superior to other fixed-income options," says Tim Ghriskey, co-founder of the Solaris Group in New York City.

Munis generally make sense for investors in the 25 percent federal tax bracket and higher, financial advisers say.

Prophets of doom

The financial crisis of 2008 and 2009 and the ensuing economic malaise wreaked havoc on state and municipal finances, leading investment luminaries, including Warren Buffett, to say a catastrophe in the muni market is likely at some point.

Most famously, in December 2010, Meredith Whitney, who leapt to fame by correctly predicting the banking meltdown, issued an ominous forecast for munis on CBS' "60 Minutes." She predicted that 50 to 100 municipalities would have "significant" municipal bond defaults in 2011, totaling "hundreds of billions of dollars."

That never happened. Many states and municipalities have cleaned up their finances in recent years. State tax collections increased for each of the past four years, though they slipped 0.3 percent in this year's first quarter, according to the Rockefeller Institute.

While Detroit filed for bankruptcy in 2013 and the U.S. territory of Puerto Rico is struggling with its municipal debt, the S&P Municipal Bond Index had a default rate of just 0.11 percent in 2013. Only 23 of more than 21,000 issues defaulted.

"Default rates tend to be low, which has remained the case, even in a tough environment, despite some predictions to the contrary," says Miriam Sjoblom, former associate director of fund analysis at Morningstar, a research firm in Chicago.

Still, the fact that there haven't been many defaults "isn't to say there may not be more," says Michael Sheldon, chief market strategist for RDM Financial Group in Westport, Connecticut. "That's something any investor has to be aware of."

Ghriskey concurs. "Certain municipal bonds carry risk," he says. "You have to do your homework. There are definitely states where bonds carry more risk."

Individual bonds vs. funds

If that doesn't scare you away, one of the first questions for investors in munis is whether to buy individual bonds, mutual funds or exchange-traded funds, or ETFs. The advantage of buying individual bonds is that you'll get all your money back at maturity, assuming the issuer doesn't default. By contrast, with mutual funds and ETFs, you could suffer unrecoverable losses.

But most individuals don't have the capability to thoroughly analyze individual bonds. "It's more difficult than corporate bonds, where balance sheets are easier to evaluate," Sheldon says.

Again, Ghriskey agrees. "It's a market where investors can benefit from professional advice, as long as the advisers are experienced and don't charge too much," he says.

Furthermore, buying individual muni bonds can be quite expensive. You can purchase them from discount brokers, but the trading commission is baked into the price rather than charged separately. So you really don't know what you're paying in commissions. And brokers aren't eager to provide bargains, especially to investors buying bonds in small denominations.

Michael Dixon, director of planning and wealth management at financial advisory firm Carl Domino in Palm Beach, Florida, views $25,000 as the minimum size that makes sense if you want to buy individual municipal bonds.

And he says you'd want at least 20 different issues to gain adequate diversity. That amounts to a minimum of $500,000 in total. His firm calls three different bond brokers when making a purchase to ensure it receives a fair price.

ETFs or mutual funds?

For those choosing muni bond funds, Dixon recommends ETFs over mutual funds. "Expenses are lower for ETFs, and they are more transparent. With mutual funds, holdings information is updated just once a quarter," says Dixon of Carl Domino Inc. Most ETFs are based on an index, so their holdings don't change much.

In addition, "we like the diversification you get through ETFs, particularly if there are states that have financial issues," Dixon says. His firm now favors funds with medium-term maturities -- five to 10 years -- so its clients can attain decent yields without being vulnerable to large losses of principal when the Federal Reserve finally raises interest rates.

The average expense ratio for a muni ETF is 0.3 percent, compared to 0.98 percent for an open-end muni mutual fund, Morningstar says.

But Sjoblom says mutual funds carry some advantages over ETFs. While ETFs are based on an index, mutual fund managers can choose their holdings as they see fit. And while some mutual funds are risker than ETFs, ETFs can have credit issues, too.

Moreover, "where liquidity is not that high, inefficiencies can be in favor of the active manager versus the indexer," Sjoblom says. "There have been sizable differences between the value of ETFs and their underlying indices."

In choosing a muni bond mutual fund, you want to start with ones that have a history of success. Sjoblom advises looking at how a fund has performed in periods of distress, such as 2008. And she recommends looking for funds with below-average expenses, as there are plenty of good ones available.

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