investing

Municipal bonds: Investing pros and cons

Bonds
Highlights
  • Interest payments from muni bonds aren't subject to federal taxes.
  • The rate of muni bond defaults was 5.5 percent per year in 2010 and 2011.
  • Should you buy individual bonds, mutual funds or ETFs?

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.

Munis generally make sense for investors in the 25 percent federal tax bracket and higher, financial advisers say. Michael Dixon, director of planning and wealth management at financial advisory firm Carl Domino Inc. in Palm Beach, Fla., sees a 30 percent rate -- combining federal, state and city rates -- as the minimum.

"Beneath that, I wouldn't touch munis today because you can get a better yield on a corporate bond or a dividend stock where you pay only a 15 percent tax on dividends," he says.

Income tax rates are currently scheduled to rise in 2013 for individuals in all the tax brackets of 25 percent and higher, which would make municipal bonds even more attractive.

"And munis currently offer more yield than many taxable bonds," says Miriam Sjoblom, associate director of fixed-income analysis at Morningstar, a research firm in Chicago.

Prophets of doom

The financial crisis of 2008 and 2009 and the ensuing economic malaise have 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. In 2010 and 2011, the average number of muni bond defaults per year was 5.5, though this was double the average defaults for the prior 39 years (2.7 per year), says Moody's Investors Service in New York.

"Default rates tend to be low, which has remained the case, even in a tough environment, despite some predictions to the contrary," Sjoblom says.

The municipalities that have defaulted, such as Harrisburg, Pa., and Stockton, Calif., had financial problems that preceded the economy's downturn. "So they were easy to spot ahead of time and still remain the exception rather than the rule," Sjoblom says.

Since the financial crisis, states and municipalities have scrambled to cut spending and raise taxes -- many of them have balanced budget requirements -- putting themselves on sounder financial footing.

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, Conn. "That's something any investor has to be aware of."

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.

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