If you haven’t thought about municipal bonds in a while, maybe it’s time you did. As the stock market struggles to get back on a bullish track, munis can become quite competitive, not to mention the distinct tax advantage they offer.

U.S. Treasury bonds are considered to be the most secure investments available today. Experts agree that the U.S. government is as solvent as they come. But muni bonds – which cities and local agencies issue to raise capital for everything from sewers to schools – are almost as solid as Treasuries when it comes to creditworthiness. Many munis, just as is true for Treasuries, do not incur local or state income taxes. What munis have over Treasuries, though, is their exemption from federal income tax.

Bonds may be bought individually, like stocks, or investors may select from a wide range of muni bond funds. Like an equity mutual fund, muni bond funds pull together a grouping of muni bonds to target various investment strategies.

The simple truth is, muni bonds aren’t a one-size-fits-all kind of product. The rule of thumb is the higher an investor’s tax bracket, the more he or she stands to benefit from munis. Those who don’t get a big bill from Uncle Sam at the end of the year could be better off sticking with equities and regular mutual funds. But then there is the issue of balance within a portfolio and virtually everyone should maintain some percentage of fixed income products. The percentage is driven by one’s goals, investment horizon, risk tolerance and tax bracket.

One additional consideration for muni funds may be the state in which you live. Residents of high-tax states such as New York may want to consider a single-state fund that holds only New York muni bonds. This way, they could avoid paying local, state, and federal taxes on the dividends because they are residents of the state in which the bonds are issued. New York residents who buy California muni bonds, for instance, would be exempt from paying federal taxes on the dividends, but they would have to pay New York State and local taxes.

Multi-state bond funds may be an option for investors in a low-tax state such as Texas. They can enjoy the benefits of greater diversification, unlike investors in high-tax states, as they don’t have to worry as much about their state and local tax burdens.

There are two schools of thought about this one. Some experts prefer the clear structure of individual bonds, with a beginning and an end date, while bond funds – which may represent a basket of hundreds of bonds that mature at different times – never actually mature. This could pose a problem for investors if they needed to pull out an exact amount from a fund on a specific date. The value of a fund’s shares can fluctuate. Another point is bond funds carry annual fees which you would not incur buying individual bonds.

On the other hand, it could take a very large sum of money to become well-diversified in individual bonds. The bond funds though, offer pools of bonds which provide the flow-through of tax-free income, diversification, the reinvestment of dividends, and professional management of your investment in the tax free bond market.

A dollar of tax-free income straight into your pocket is worth more than a comparable sum of ordinary income. How much more depends on the tax rate that applies in your income tax bracket in the state where you live. Take, for example, a married couple living in New York City who file a joint return on $166,451 a year. Because of where they live, the tax return they filed in 2001 (combining city, state and federal taxes) was in a tax bracket of 42.5 percent. So to them, 5 percent triple tax free (no city, state or federal taxes) would have been nearly 8.7 percent from a bank or other taxable investment that year. Even in 2006, when the final tax cut is phased in, 5 percent and no tax will still be the equivalent of 8.33 percent taxable. For a couple like that, muni bonds are very attractive.

With the stock market having withdrawn from the bullish growth of the 1990s, it pays to give muni bonds a closer look. Talk to your financial advisor about how munis might help your portfolio and provide a needed fixed-income element to your investments.

Marc Pellerin has been in the investment industry since 1979. He is an associate vice president and portfolio manager with the Advest Managed Portfolio Service Team, which manages in excess of $450 million in client assets.

Marc A. Pellerin is an associate vice president and investment advisor with Advest Inc. in Lewiston.

Copy the Story Link