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Tax-free income investments

By Sheyna Steiner · Bankrate.com
Friday, March 25, 2011
Posted: 11 am ET

Municipal bonds have been the subject of an unusual amount of interest in the past year. Most of the attention has been negative as a result of some dire predictions for state and local finances from high-profile analysts.

Since November, municipal bond funds have seen more money going out than coming in, according to Investment Company Institute statistics, with $39.6 billion leaving municipal bond funds through the week ending March 16.

Even with uncertainty running high, muni bond bears aren't advocating a wholesale rejection of tax-free bonds.

A Reuters story published on Wednesday, "Cohen sees 'train wreck' in muni bond market," reported that Marilyn Cohen, author of the ominously titled, "Surviving the bond bear market: Bondland's nuclear winter," is advising her clients to buy specific types of individual tax-free bonds.

Cohen, also the president and CEO of Envision Capital Management, "is advising her clients to buy individual bonds selectively, shorten their durations, buy pre-refunded bonds that are escrowed only by U.S. Treasuries, to diversify and to take less yield today to keep opportunities open for tomorrow," the story said.

Escrowed-to-maturity bonds and pre-refunded bonds are types of refunded bonds. Refunded bonds are backed by collateralized Treasury securities or other securities, making them among the safest municipal offerings.

Here's a better explanation. Back in January, Donald Cummings, managing partner at Blue Haven Capital, in Geneva, Ill., wrote a blog post entitled, "Getting around municipal bond default risks." He wrote:

"When an individual borrows high and sees rates drop, such as with a mortgage, the individual can go and borrow at a new lower rate and pay off the higher rate mortgage with the newly borrowed money. Municipalities do much the same. High interest rate debt from years ago can be refinanced with money borrowed at lower rates. The older municipal bonds that get paid off are escrowed to maturity or pre refunded ... often by US Treasuries ... which are held in an escrow account and are used to pay the principal and interest of the old bonds. In effect, the holder of an escrowed or pre refunded bond has a tax exempt municipal bond backed by US Treasuries paying tax exempt interest.

"Along with names such as Harrisburg PA, various escrowed and pre refunded bonds have similarly gotten cast aside by investors rushing for the exit doors in order to avoid municipal defaults. Currently, many escrowed and pre refunded munis are trading cheaper than Treasuries. That's right -- cheaper -- than Treasuries, which has happened only a handful of times since the mid 1980s."

The ongoing perception of risk in the entire municipal bond market could benefit investors looking for high-quality tax-free bonds -- if they're willing to look past the fears and do some homework.

As this Bankrate story recommends, investors interested in buying individual municipal bonds would do well to speak with an investment professional.

What do you think? Are municipal bonds an option?

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1 Comment
CLARE WEINSHENKER
April 21, 2011 at 11:39 am

I HAVE A MUNICIPAL BOND PURCHASED AT A PREMIUM THAT HAS BEEN CALLED AT PAR BEFORE MATURITY. THE PURCHASE PRICE INCLUDED A PAYMENT FOR ACCRURED INTEREST.

HOW DO I CALCULATE THE BASIS OF THE BOND IN ORDER TO FIGURE THE CAPITAL GAIN OR LOSS ON ITS "SALE"?