investing

Municipal bonds attractive as a tax haven

 

What they are

Municipal bonds are debt securities issued by governments in states, cities, counties and towns. They are particularly appealing to investors because of their tax-exempt status. The interest earned on most muni bonds is free from federal taxes and, in some cases, state and local taxes as well.

How they work

Municipal bonds are securities that represent a loan by investors to the issuer. Just like a CD, the issuer pays a coupon, or a stated amount of interest, for a set period of time, known as the maturity.

The bond may fluctuate in value throughout its life. Investors who hold a bond until maturity, however, will get their full investment back in most cases. In the rare event the issuer defaults, investors may get all, some or none of their money back.

Advantages and disadvantages

The advantages of municipal bonds are in their tax-exempt yield. They appeal to investors looking for ways to limit the amount of income tax they pay, and they can end up actually yielding more than taxable bonds once the tax break is considered.

On the downside, some local governments are stronger than others, and the 2008 financial crisis exposed some of the weaker states and cities. Before buying a municipal bond, investors should investigate the credit quality of the issuer.

Considerations

If the possibility of defaults has you leery of investing in municipal debt, consider pre-refunded or escrowed-to-maturity municipal bonds.

"In the muni bond market, both taxable and tax exempt on the pre-re and escrow side still give good yields," says Donald Cummings, founder and portfolio manager at Blue Haven Capital in Geneva, Ill.

Pre-refunded and escrowed-to-maturity municipal bonds are typically backed by investments in U.S. Treasuries and are considered fairly safe.

Here's how they work in a nutshell: A municipal bond issuer may decide it wants to refund a bond that investors already hold. Why? The bond may be too expensive or have unfavorable terms the issuer wants to shed.

It can issue a new bond and take the proceeds from selling it to buy Treasury securities, which are placed into an escrow account. Instead of Treasuries, they may buy Fannie Maes or Freddie Macs or other securities. The interest payments from the securities then go to pay interest on the outstanding old bonds.

In most cases, investors with bonds that are escrowed-to-maturity will continue to receive payments from the collateralized securities until their bonds mature. However, in some instances the bonds may be called early.

Investors of pre-refunded bonds will receive payments until the call date, at which point the bonds are called back and redeemed with the funds from the escrowed accounts.

With both the pre-refunded or escrowed bonds, the escrow account is used to pay both principal and interest.

 

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