Tax-free municipal bonds — Part 2

In last month's column, we discussed the basics of the municipal bond market. Municipal bonds are attractive because the interest is not subject to federal taxes.

Marvin Appel, PhD, and Brian Hufford, CPA

In last month's column, we discussed the basics of the municipal bond market. Municipal bonds are attractive because the interest is not subject to federal taxes. Bonds issued by municipalities in the state where you live, or by your own state's government, generally are exempt from state income taxes as well. This additional benefit can be valuable in high-tax states such as New York or California.

Why consider municipal bond mutual funds?

If you purchase individual bond issues from a broker, the minimum investment is usually $5,000 to $10,000 for each bond. This means that in order to diversify your holdings among at least five different bonds, you may need roughly $50,000 or more.

Mutual funds remove this obstacle. An investment of under $5,000 can buy a piece of a highly diversified portfolio.

The second major advantage of mutual funds is liquidity. If you buy a bond and then try to sell it back, you will likely receive from 2 to 5 percent less than you paid (assuming no change in market conditions). This high cost of exiting your investment in individual bonds forces you to limit your purchases to an amount of capital you feel certain you won't need before maturity.

Disadvantages

The principal disadvantage of investing in municipal bond mutual funds compared to investing directly in bond issues is the added expense of the mutual fund. The average tax-exempt bond fund has expenses of approximately 1 percent per year. At current interest rates, even a 1 percent expense ratio represents a significant reduction in interest income.

For example, top-rated 10-year municipal bonds now pay roughly 4 percent per year. A fund portfolio yielding 4 percent before expenses would generate only 3 percent per year after a 1 percent expense. In other words, the expense ratio acts like a tax that takes a quarter of the income away from the investor.

The lower the yield of a mutual fund portfolio, the worse the effect of its expense ratio. The negative impact of expense ratios is especially problematic for short-term municipal bond funds. In some cases, the impact of the expense ratio of a municipal bond fund can be so severe as to make the after-tax return on the fund worse than the after-tax return on a taxable bond fund.

The best way to hold on to superior after-tax returns when investing in municipal bond mutual funds is to choose low-expense funds. Fund expenses assume the greatest importance when interest rates are low across all maturities, as they are now.

An additional disadvantage of a bond mutual fund is that the share price can always fall further if interest rates rise over a prolonged period. This means that if you invest $1,000 in a bond mutual fund there is no guarantee that you will get your full $1,000 back because mutual funds have no maturity date. Rather, they continuously reinvest cash from maturing bonds and interest payments in new bonds. In contrast, if you buy a bond at its par value ($1,000) and hold it until maturity, you will get your $1,000 back, despite interest rate fluctuations (assuming the issuer does not default).

As a general observation, the best balance between risk and reward has been achieved with intermediate term bond funds. Our two favorite intermediate term municipal bond funds (based on superior performance relative to risk over the past three, five and 10-year periods) are Fidelity Spartan Muni Intermediate Term (ticker symbol FLTMX), and Vanguard Intermediate Term Tax-Exempt (ticker symbol VWITX).

Investors with under $25,000 to invest should limit themselves to either or both of these funds. If you have more than this amount, you should investigate the possibility of buying individual municipal bonds. Before investing with brokers, have them propose a bond portfolio for you, and ask specifically for the lowest possible commission. Make sure the proposal describes the credit quality, duration or maturity, and the yield to maturity. Then compare the proposal to other brokers' proposals and to the most recent data you can obtain from the mutual funds above.

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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