Tax-free Municipal bonds — Part 1

Tax-free bond mutual funds have been very profitable during the past three years, returning an average of more than 7 percent per year — much of that in the form of tax-exempt interest income.

Marvin Appel, PhD, and Brian Hufford, CPA

Tax-free bond mutual funds have been very profitable during the past three years, returning an average of more than 7 percent per year — much of that in the form of tax-exempt interest income. Now, however, there are a number of reasons to re-evaluate the attractiveness of this investment area. We will examine the pros and cons of municipal bonds under current conditions in this and upcoming columns.

Municipal bond basics

In previous columns, we reviewed some key properties of bond investments — maturity, yield, credit risk, and interest rate risk. Briefly, rising interest rates go along with falling bond prices. The longer the maturity, the more the value of your bond investment will swing when interest rates change. These properties are important in evaluating tax-free bonds as well as taxable bonds.

Tax-free bonds are loans made to state and local governments or agencies. The bonds may be backed by the entire taxing authority of the issuing government (general obligation bonds), or may be backed only by the revenues from a specific public works project such as toll bridges (revenue bonds). All else being equal, a general obligation bond should be safer than a revenue bond because, in theory, a government can always raise taxes sufficiently to cover its debt obligations.

Many governments purchase commercial insurance to guarantee bondholders against default. Such insured bonds then receive the rating of the insurance company (generally AAA — the top rating) even if the issuing government by itself would be considered less creditworthy. Insured municipal bonds are safer than uninsured bonds, so they have lower yields. Naturally, insurance companies themselves can possibly default, especially if many bond issuers were to default around the same time. You should diversify your investments in municipal bonds by region and by insurance status to minimize your exposure to potential isolated catastrophes.

After-tax yields remain attractive

The major advantage to municipal bond investors is that interest income is generally free of federal and other income taxes. So, for example, if you are in a combined 35-percent state and federal income tax bracket, a yield of 5 percent per year from a taxable bond will give you the same after-tax income as a yield of 3.25 percent from a tax-free bond. During the past 35 years, municipal bond yields have generally been more attractive than Treasury bond yields on an after-tax basis for high-earning professionals.

Currently, on an after-tax basis, top-rated municipal bond yields are generally far more attractive than top-rated taxable bond yields for the tax brackets in which most dentists should find themselves.

However, caveat emptor. Some municipal bond investments may not be tax-exempt, and others may be subject to the AMT (Alternative Minimum Tax). You need to consider your individual tax situation and the special properties of each bond investment when you evaluate the potential benefits of a tax-free bond or mutual fund.

Municipal bond risks

Municipal bond yields are at the lowest levels in 35 years. For example, 10-year, top-rated municipal bonds are now yielding just 3.4 percent per year — below the average rate of inflation during the post-WWII period. One of the reasons municipal bonds have done so well in recent years has been the decline in inflation. However, in recent weeks, the fear of inflation has grown. Municipal bond yields at current levels do not afford much protection to your purchasing power if prices should accelerate upward.

Meanwhile, state and local governments across the country are facing budget crunches as tax revenues have failed to keep up with rising expenditures (including the costs of unemployment which has continued to rise). As a result of budget pressures, new municipal bonds are being issued at record volumes.

Implications

Municipal bond yields are attractive on an after-tax basis relative to taxable investment-grade bonds. However, the bond market appears precarious enough to warrant caution. You should invest in short- to intermediate-term municipal bond vehicles (maturing in seven years or less), and emphasize higher-quality lenders.

In the next column, we will discuss how to select tax-free bond mutual funds.

Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or mappel@appelasset.com. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.

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