Municipal bonds have long been a safe haven for higher-income investors looking for safety and greater tax efficiency. The credit squeeze put the municipal bond market through its paces this past year, but now may be time for a second look.
A municipal bond is issued by a local government to raise funds for (mostly) projects such as water, sewer, transportation and schools. As an incentive for investors, interest income is often exempt from federal income tax as well as the income tax of the state in which they are issued. Portfolios that invest in municipal bonds also offer the same tax treatment.
The recent credit crunch took away funding sources for public projects and many municipalities ended up dropping certain projects due to a lack of investors and other financing sources. Those leaving the muni market have included hedge funds, issuers of structured notes and diversified portfolios of municipal bonds keeping up with redemptions. But in the absence of other buyers, that’s potentially good news for you. Keep in mind that even during the Great Depression, no state defaulted on its general-obligation bonds and while some munis have defaulted, overall, such defaults are very, very rare.
So where’s the opportunity for you? Look at some existing highly rated bonds. The credit crunch has beaten down prices, sometimes irrationally so. Because of this, you’ll find yields you currently won’t find in CDs and other investments. Some municipals are offering long-term, tax-free yields of five percent or more.
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But before you buy, consider the following:
1. Are munis right for you? Talk to your tax professional or your certified financial planner about your entire taxable investment portfolio to determine if it is appropriate for you. While munis are federally tax-free, other state and local taxes may apply. And bond values may decline as interest rates rise so be sure which of your income/investment needs they will meet before investing.
2. Watch those ratings. The ratings firms like Moody’s and Standard & Poor’s have been in the “doghouse” for rating many battered investments highly, but most municipals rated AA or AAA are generally safe to consider. Check the issuer’s long-term ratings history and the Internet news archives to confirm the municipality has had no financial scandal recently.
3. Consider the alternative minimum tax. Some muni interest is subject to the alternative minimum tax, which won’t affect you if you’re already in a high tax bracket, but that’s why you should talk to your financial professional before investing. You can avoid this tax if you choose wisely.
4. Consider a “ladder.” To “ladder” bonds means that you are buying them with maturities staggered over several intervals, so at maturity, you can reinvest at those same regular intervals. This helps to protect against interest rate risk.
Karin Grablin, a certified financial planner is with Dictor & Martin, Personal CFOs, Two N. Tamiami Trail, No. 608, Sarasota, can be reached at (941) 906-7222. Securities are offered through LPL Financial, member FINRA, SIPC and a registered investment adviser.