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This chapter is from the book

Municipal Bonds—Don't Share with the Tax Collector

So far we have talked about bonds issued by the federal government and by companies looking to borrow money. State and local governments, as well as separate agencies that they sponsor, also need to borrow money from time to time. The big attraction to buying bonds issued by state or local governments, called municipal bonds, is that the interest they pay is generally not subject to federal income tax.9 Moreover, if your home state has a state income tax and you buy bonds issued by a government entity within your state, you will probably escape state income taxes as well.

This can be very beneficial to investors in high tax states who are in the top tax brackets. For example, if your combined state and federal tax burden is 40%, a taxable bond paying 6% will generate only 3.6% interest for your benefit after you pay the taxes due. If you could get 4% tax-free from a municipal bond, then that would be a better deal for you, all else being equal. As a general rule, on an after-tax basis, municipal bonds tend to pay more than taxable bonds for high-bracket investors. If you are in a relatively low tax bracket, as many retirees are, then municipal bonds may not be for you. You should calculate the after-tax yields (using yield to maturity) from the different bond investments available to you before you commit to municipal bonds.

Unlike the U.S. Treasury, state and local governments cannot print money to pay their debts. As a result, just like corporate bonds, municipal bonds have credit risk and they generally carry credit ratings. Municipalities can buy insurance for their bonds. Insured municipal bonds carry the highest credit rating, implying low risk. However, in theory, insured municipal bonds are only as safe as the insurance company that guarantees them, which is good but not perfect.

There are a number of mutual funds that invest in municipal bonds. Although they afford excellent portfolio diversification and liquidity, their expenses are usually a big drawback. To see why this is an especially severe problem for municipal bond investors, let's return to the example of a taxable bond portfolio paying 6%/year in interest (yield to maturity) and a municipal bond portfolio paying 4%/year. Recall that an investor in a 40% tax bracket would fare better with the 4% tax-exempt bond portfolio.

However, if these portfolios are held by mutual funds with 1% expense ratios, then the yields generated for investors are reduced by 1% in both cases, down to 5% for the taxable bond portfolio and 3% for the municipal bond portfolio. The mutual fund's expenses represent, in effect, a tax of 1/6 of the taxable bond yield (1% out of 6%), but a higher effective tax of ¼ of the tax-exempt bond yield (1% out of 4%). Net of the mutual fund's fee, the returnsof the municipal bond fund are no longer better than the returns of the taxable bond fund on an after-tax basis. For this reason, we recommend that you utilize only the least expensive tax-exempt mutual funds—those with expenses of 0.3%/year or less. That pretty much limits you to offerings from Vanguard, or to the Fidelity Tax-Free Bond Fund (FTABX). Table 7.3 lists selected offerings from Vanguard that we have found useful in the past. Under current bond market conditions, the tax-exempt money market is the best bet because it pays the same yield as the other bond funds, but does not expose you to any interest rate risk. In addition to the funds listed in Table 7.3, Vanguard offers a number of funds holding bonds from single states that are designed specifically for residents of those states.

Table 7.3. Selected Tax-Exempt Bond Funds from Vanguard

Vanguard Fund

Ticker Symbol

Yield10

Expenses

Tax-Exempt Money Market

VMSXX

3.59%

0.13%

Short-Term Tax Exempt

VWSTX

3.52%

0.16%

Intermediate-Term Tax Exempt

VWITX

3.73%

0.17%

There is one exceptional municipal bond fund that we have used successfully for our money management clients over the years: The Nuveen High Yield Municipal Bond Fund (NHMAX). Even though its expenses are 0.88%/year, its performance net of expenses has been better than the low-expense offerings from Vanguard and far better than the average tax-exempt bond mutual fund since its inception in 1999. You should only purchase NHMAX without paying a sales charge to a full-price broker. The fund is available through discount brokerages such as Schwab and T.D. Ameritrade.

An alternative to tax-exempt bond mutual funds is to buy individual municipal bonds, for which you need to go through a broker. The process is murkier when you use a broker to buy bonds than it is with stocks because with bonds, there is no explicit commission. Rather, the price of the bond you are buying is marked up from the dealer's cost. Typically, the mark-up is 1–2% of the amount you are investing. If you buy a portfolio of individual bonds with an average maturity of 10 years, and you pay the dealer a mark-up of 2% in doing so, then you have effectively incurred an expense of 0.2%/year. This is less than what the vast majority of bond mutual funds charge. Although the Vanguard funds listed in Table 7.3 have lower expense ratios than 0.2%/year, the funds too must bear the impact of paying a mark-up to whomever sells bonds to them. (Presumably as large buyers, they should be getting a better price for their bonds than an individual investor could.) You should not take the 2% one-time cost for granted, however. At times, unwary customers have been known to pay mark-ups as high as 5%.11

The usual minimum amount you can invest in any single bond is $10,000 without paying a very high mark-up, so in order to diversify among several different bond issues, you would need a relatively sizeable portfolio (at least $50,000) compared to the $3,000 minimum investment required to get into the mutual funds listed in Table 7.3. You should also purchase only individual bonds that you are highly confident of holding until maturity, because selling bonds back to a dealer is like trading in a used car: In order for the dealer to make his profit, he has to pay you something below the true market price.

Here are some tips for investing in individual municipal bonds:

  1. Ask the prospective broker for his proposed portfolio, its average maturity, its average credit rating, its duration, and its yield to maturity. Compare that to the similar portfolio characteristics for one of the bond funds listed in Table 7.3, which are available online at www.vanguard.com.
  2. Be sure to specify when placing an order through a broker that you want to pay the minimum that his firm allows. (Brokers have a certain amount of discretion to lower the prices from their initial quote; for example, the price they might quote on a firm website.)
  3. Sometimes bond dealers have what are called odd lots to sell. Normally, a broker wants to transact in round lots, which are multiples of 10 bonds. If in their inventory they have a smaller amount (say $5,000) of a particular issue, they might be willing to let it go at a lower price just to save themselves the trouble of keeping records on what for them is a very small investment.

For most individual investors, one of the recommended municipal bond mutual funds is likely the best way to go. However, issues for you to consider with regard to your own situation in choosing the best way for you to invest in bonds are listed in Table 7.4.

Table 7.4. Pros and Cons of Owning Individual Municipal Bonds Versus Municipal Bond Mutual Funds

Factors That Favor Using a Broker to Buy Individual Bonds

Factors That Favor Using Bond Mutual Funds

If you want a customized portfolio. (For example, if you live in a state for which an economical single-state municipal bond fund is not available.)

If one of the recommended bond mutual funds meets your needs.

If you want to know the exact income stream from your bond investments at the time you make them.

If there is a significant chance that you might want to cash out some or all of your bond investments before maturity.

If you are concerned about the possibility of an alternative minimum tax liability. (Some interest paid by muni bond funds is subject to the alternative minimum tax. If you select individual bonds, you can avoid that pitfall.)

If you have under $50,000 to invest in municipal bonds.

If there is no low-expense municipal bond mutual funds that meet your needs, and you have a broker you trust.

Different Types of Bond Investments to Suit Your Style

All bond investments are based on the basic principles we have covered so far. To review:

  1. Bonds are loans that pay you, the lender (bondholder), interest during the term of the loan. At maturity, you receive the original face value of $1,000 per bond.
  2. Changes in interest rates cause the values of existing bonds to change. A fall in interest rates increases the values of existing bonds. A rise in interest rates decreases the values of existing bonds.
  3. A bond's credit rating is the assessment of a rating agency of its level of confidence that the borrower will be able to meet its obligations to pay interest and return principal to bondholders. Investment-grade bonds have relatively high credit ratings and a very low risk of defaulting. High yield bonds have below investment grade credit ratings, have a potentially significant risk of defaulting, and for this reason must pay higher rates of interest to investors.
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