Dear Dr. Don,
Where does one buy municipal bonds? I’d like to diversify my portfolio, but I’m not sure where to go.
— Derrick Domain

Dear Derrick,
I picked your question after a federal judge allowed Detroit to pursue reorganization under bankruptcy. It is one cautionary tale about the risks associated with municipal bonds.

Municipals — or munis, as they’re called in the trade — are purchased either in the primary market when an issuer sells a new bond, or in the secondary market from another investor. Primary market issues are purchased through the investment banking team underwriting the security offering, which are typically brokerage and banking firms. Secondary market purchases are made through brokerage firms.

Rather than owning individual munis outright, you can buy shares of mutual funds investing in municipal bonds. There are also muni exchange-traded funds, or ETFs. For tax reasons, you may want to own funds or ETFs that invest only in muni obligations of your home state or locality. The decision to own individual munis, muni mutual funds or ETFs depends on your investment expertise, investment goals, risk tolerance and tax planning.

Investors subject to the alternate minimum tax should be concerned about which munis they own. Interest income from private activity municipal bonds is subject to the AMT. If in doubt about this, one should speak with a tax professional.

Munis are debt instruments issued by state and local governments. Muni interest income is exempt from federal income tax. Many, but not all states will also exempt the interest income from your state income tax when you buy munis issued in that state. New York City residents buying New York munis can get a triple tax exemption from federal, state and local income taxes. Puerto Rico and U.S. Virgin Island bonds have a special triple tax exemption for investors from all states, but Puerto Rico has had some recent budgetary issues impacting the value of its bonds.

Once you know your state and local governments’ rules concerning income taxes, you can use Bankrate’s tax equivalent yield calculator to compare muni rates. Many muni investors compare muni yields to those of U.S. Treasury bonds. You should also consider the differences in risk.

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