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Should You Invest in Municipal Bonds?

Answers to 9 common questions about tax-free bonds

Municipal bonds explained for Dummies-iron grates and tall buildings

Municipal bond interest is exempt from federal income tax and also from state and local taxes if the bond was issued in your state of residence. — Photo by Gallery Stock

En español  |  Municipal bonds tend to rank high on the list of investments that financial planners recommend to people who are nearing — or who’ve reached — retirement. They’re known for their relative safety and generous tax breaks and, perhaps most importantly, for preserving capital.

But “munis,” as they’re commonly known, have exhibited some uncharacteristic swings in recent years, raising questions about how safe they really are. The consensus among financial planners is that the bonds remain a good option for older investors, as long as you do your homework.

Here are answers to 9 common muni questions.

1. So just what are municipal bonds?

They’re essentially IOUs issued by state or local governments, government agencies and sometimes private companies that are working on projects with governments. There are two types of munis. General-obligation bonds finance basic government operations and are repaid from tax revenue. Revenue bonds, however, pay for specific projects such as power plants or sewage treatment facilities. The project’s eventual revenue — electric bills, bridge tolls and so on — goes to cover repayments.

2. How do you make money with them?

Munis typically have fixed interest rates, so you receive identical income payments, usually every six months, until the bonds reach maturity and principal is repaid. Maturities generally range from one year to 30 years, though some go even longer.

Bonds with longer maturities tend to pay higher rates because their prices in resale markets are more sensitive to fluctuations in interest rates and inflation. The higher rates in munis are a way of compensating you for accepting greater volatility, which means a higher risk of loss if you need to sell your bonds before maturity.

3. How or where do you buy munis?

You can buy single municipal bonds, which come in minimum denominations of $5,000. Another option that’s likely less volatile is mutual funds that hold many different muni issues. Single bonds and shares in funds alike can be bought through brokerage firms, just like stocks. At discount brokerages it’s often possible to buy mutual funds without paying a commission.

4. How is muni income taxed?

Very lightly. Municipal bond interest is exempt from federal income tax and also from state and local taxes if the bond was issued in your state of residence. That means you end up with more money in your pocket than if you held taxable bonds, such as Treasuries, or corporate bonds that pay the same interest rate.

These tax breaks can be especially useful if you’re an older investor — you may well have fewer tax deductions than younger taxpayers and rely more on interest income for your living expenses.

5. What about the alternative minimum tax?

Income from certain municipal bonds may be subject to the alternative minimum tax, which limits what the federal government deems to be excessive deductions for certain taxpayers. Financial planners say retirees generally must be quite well off before the AMT affects them.

Social Security is also a potential tax issue if you’re collecting benefits. Muni interest is tax-exempt but still figures in the formula used to determine whether any of your benefits are taxable.

6. Are there any risks?

Municipal bonds fell in value about a year ago as analysts began predicting more defaults by issuers. Sluggish economic growth and reduced tax revenue had slammed spending by state and local governments. But defaults have actually decreased recently and history suggests that the chance of a default on high-grade munis is minimal.

7. So risk is no concern at all?

Not quite. There are still potential pitfalls.  As with all bonds, if inflation and interest rates go up, the purchasing power of interest income is likely to decline — as would bond prices. That could mean taking a loss if you need to sell your bonds before they mature.

8. So, what’s the case for buying munis now?

“Most municipalities have tightened their belts,” says Bill Walsh, president of Hennion & Walsh, a Parsippany, N.J., financial advising firm. “They have spent less money, provided fewer services and become fiscally responsible in recent years.” That means less chance of default.

And if tax rates rise as a result of a deficit reduction deal in Washington — as some analysts predict — munis with their protection from taxes will become more valuable.

9. What types of bonds should I focus on if I want to raise my potential returns and keep risk low?

The consensus is: Stick with high-quality bonds that may provide a bit less income but far greater security. “For a conservative investor who wants to buy munis and not worry about them, our advice is to own A-rated general-obligation and essential-service bonds,” says Patrick Early, chief municipal analyst at Wells Fargo Advisors. Essential service bonds are ones used to finance the most vital projects, such as power and sewage plants.

Also of interest: Check out our Investment Returns calculator. »

Conrad de Aenlle has written articles on finance and investment for more than 20 years.

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