Investing in Municipal Bonds

By: Jonathan D. Pond | Source: AARP.org | January 6, 2009

The primary attraction of investing in municipal bonds is that the interest they pay is generally not subject to federal income tax. Further, if you reside in the state where the municipal bond was issued, the interest is probably also exempt from state income tax.

Since investors receive tax-free interest income from municipal bonds, the interest rate paid on them is almost always lower than the rate of taxable bonds, including U.S. Treasury bonds. But recently, municipal bond interest has been higher than U.S. Treasury security interest—a rare event. Municipal bonds are more attractive now than they have been in a generation. While municipal bonds are thought to be appropriate for investors in the highest tax brackets, rates are so attractive now that investors in more modest brackets are likely to benefit as well.

But caution is advised. One reason that municipal bond interest is so high is that the fiscal situation in many municipalities and several states is dire. There is a possibility that at least some municipal bond issuers may have difficulty in meeting their obligations to pay interest and to repay the principal at maturity on bonds they have issued. So, you not only have to be careful in selecting individual municipal bonds, but you must also monitor them regularly lest the issuer get into trouble—which could affect both the interest you receive and/or the value of the bond.

All in all, municipal securities are worth a look right now because their interest rates won’t stay this high forever. There are two ways to add municipal bonds to the investments you hold outside retirement accounts: 

1. Individual municipal bonds. If you’ve got an abundance of money and have experienced and trustworthy investment counsel and/or previous experience in evaluating and buying municipal bonds, you might be able to put together your own portfolio of individual issues. Be sure to assemble a portfolio of at least several different bonds, comprising only the highest quality municipal bonds—those rated AAA or at least AA by Moody’s and Standard & Poor’s, the two most prominent bond rating services.

Don’t put much faith in insured municipal bonds. The municipal bond insurers became involved in the subprime mortgage crisis, and their ability to make good on failed municipalities cannot be assured. My recommendation is to opt for high quality muni bonds backed by projects that are not likely to suffer unduly if the state’s finances become strained. These examples include bonds supporting educational facilities and essential services like water and sewer.

2. Municipal bond mutual funds. Since municipal bond prices do not appear in the daily papers and they are inconvenient for the average investor to buy and monitor, municipal bond mutual funds are a useful way to invest in them while avoiding these problems. Many mutual fund companies have large staffs dedicated to identifying the best municipal bond investments and then monitoring them closely thereafter. This is particularly important as the financial strength of some states and municipalities deteriorate. Also, owning a municipal-bond mutual fund will address the high cost of buying a diversified portfolio of individual bond issues that could cost more than $100,000. Here are a couple of recommendations:

• Avoid high-yield municipal bond funds, which are funds that hold lower-rated bonds. This is no time to be investing in shaky borrowers. Stick with funds that emphasize high-quality bonds and have a good track record.
• If you reside in a state that assesses high income taxes, you should first consider a “single-state” municipal bond fund if you can identify a good one for your state.    

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