When the stock market was roaring, many people overlooked tax-exempt and tax-favored bonds. Risk-taking investors instead turned to stocks and other investments with higher returns.

But thanks to the current economic downturn, conservative investors may be taking a second look at bonds, which are viewed as safer, more dependable places to park money.

In particular, tax-exempt bonds may be attractive to investors in higher tax brackets who keep money in taxable accounts, according to Adrian Stern, a certified public accountant and founding member and partner of Clumeck Stern Schenkelberg & Getzoff in Encino, Calif.

“The higher the tax bracket, the higher the yield and the (more) beneficial the tax-free bond will be to this person,” Stern says.

Certified Financial Planner Marilyn Capelli Dimitroff agrees.

“Those who could benefit most are the individuals in the 33 percent and 35 percent tax bracket,” says Dimitroff, chair of the board of directors of the Certified Financial Planner Board of Standards and president of Capelli Financial Services in Bloomfield Hills, Mich.

“The higher the tax bracket … the (more) beneficial the tax-free bond will be to this person.”

However, the safety of tax-exempt and tax-favored bonds comes at a price. Bond investors must be realistic about the type of return they can expect, Stern says.

“Risk reward is not an idle statement,” Stern says. “If you want the reward, you must take the risk. The lower the risk, the lower the reward.”

Following are several types of tax-exempt and tax-favored bonds and bond funds:

Municipal bonds

Municipal bonds are bonds issued by state and local government agencies. The interest income on these bonds is free from federal taxes.

In most cases, they are also exempt from state and local taxes when investors purchase bonds issued within their state and municipality. However, the capital gains associated with municipal bonds are taxable.

There are many different types of municipal bonds, but two key types are:

  • General obligation bonds. Often called “GO bonds,” the principal and interest of these bonds are backed by the full faith and credit of the municipality that issues them. For this reason, they are considered relatively safe.
  • Revenue bonds. The principal and interest payments of these bonds are funded from project revenues. Revenue bonds are considered riskier, since they are secured by a stream of income provided by the issuing facility. For example, a state may issue bonds and use state toll collections to cover the debt-service payments.

In many cases, issuing agencies insure their bonds, giving investors an extra assurance the principal will be repaid on an issue. Riskier municipal issues pay higher interest rates because of the additional risk.

Municipal bonds can be purchased through a stock broker. They traditionally have been issued in minimum amounts of $25,000, but it’s become increasingly common to find bonds in $5,000 and $10,000 increments, according to Stern.

When considering a purchase of a municipal bond, it’s important to ask the right questions, Stern says.

“Individuals looking for a bond should not only inquire whether it is a government obligation or a revenue bond to evaluate its risk, they should also find out … whether the bond is insured,” Stern says.

Some experts recommend using a financial planner or other expert when investing in municipal bonds.

Municipal bond funds

Investors who don’t see themselves shelling out $5,000 for an individual municipal bond can opt instead to purchase shares in a municipal bond mutual fund.

These funds offer the same tax benefits as individual municipal bonds, with the added bonus of reducing risk to the investor. Owning a basket of municipals in a fund means the investor will not suffer greatly if one single bond defaults.

“Muni bonds funds are best for a regular investor because they are high quality, insured and provide diversity,” Stern says. “Instead of buying just one state bond, the fund offers a group of bonds from different states.”

As with individual municipal bonds, the interest income the municipal fund produces is tax-exempt while the capital gain is taxable.

“A regular investor can take part (in) a muni fund,” says Timothy Atkinson, a Certified Financial Planner and president and portfolio manager of Excomp Asset Management in Garden City, N.Y. “Depending on the company offering the fund, the minimum required balance could be as little as $100.”

To protect his clients from having to pay out-of-state taxes, Atkinson makes sure clients only participate in municipal funds issued by their state — that way, the interest income is also exempt from state and local taxes.

Government bonds

Unlike municipal bonds, which are often almost completely tax-exempt, bonds issued by the federal government bonds are free from state and local taxes but not federal taxes.

“The only tax-exempt bonds are the municipal bonds,” Dimitroff says. “Other Treasury products like I bonds, EE Series bonds and TIPS are tax-favored.”

Government bonds that offer some tax protection include:

  • Series EE savings bonds. These bonds are issued at a deep discount from face value (par) and pay no annual interest because the interest accumulates within the bond and is paid at maturity. The interest on these savings bonds is subject to federal taxes but can be deferred until maturity or redemption. However, if the interest is used to fund a qualified educational expense, it is tax-free.
  • Series I savings bonds. More commonly known as “I bonds,” these pay a combination of a fixed interest rate (set when the investor buys the bond) and a semiannual variable interest rate tied to the inflation rate. Earnings on these bonds are exempt from state and local taxes. Similar to EE bonds, I bonds are exempt from taxes if used to pay qualified education expenses.
  • Treasury bills. More commonly known as “T-bills,” these are short-term securities that mature in one year or less. You buy them for less than par value. When the bill matures, you receive par value. For example, you might buy a $1,000 26-week T-bill for $985. If you hold it until maturity, you’ll be paid $1,000. That extra $15 is the interest you earned.
  • Treasury notes. More commonly known as “T-notes,” these are issued in terms of two, three, five, seven and 10 years and pay interest every six months until they mature. The price of a note may be greater than, less than or equal to the face value of the note, depending on demand. If demand by investors is high, the notes will trade at a premium, which effectively reduces investor return. Upon maturity, investors are paid face value.
  • Treasury inflation-protected securities. More commonly known as TIPS, these bonds protect investors against inflation because the principal is adjusted every six months to keep pace with higher prices as determined by the Consumer Price Index. Thus, when the inflation rate increases, the principal amount also increases.

Government bond funds

Government bond funds only invest in debt securities issued by the U.S. government. The funds are made up of Treasury bills, notes, bonds and mortgage-backed securities issued by government agencies.

The securities within the fund are backed by the full faith and credit of the U.S. government. Taxes for government funds follow the same rules as the individual bonds held within these funds.

The funds specialize in varying maturity terms of five years or less (short-term funds), five to 10 years (intermediate-term funds) or 10 to 30 years (long-term funds).

Values of these funds fluctuate based on changing interest rates. If rates go up, the bond fund value decreases. If rates go down, the fund increases in value.

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