Municipal bonds have become an exciting investment

Eileen Ambrose

September 7, 2008

Municipal bonds are exciting this year - just what their investors hate.

The latest thrill occurred about a week ago. Alabama's largest county barely avoided filing the largest municipal bankruptcy in U.S. history as it struggles to keep up with payments on its sewer bonds. That has raised concerns that other municipal bonds could face similar challenges as cities, states and other issuers nationwide grapple with weakening tax revenue and a fallout from the subprime mortgage bust. States and local governments issue municipal bonds to finance the construction of schools, stadiums, hospitals, roads and bridges. Investors in high-income tax brackets favor the bonds because the interest income generated is exempt from federal taxes and, in some cases, state taxes. Investors also flock to municipal bonds for safety.

But this year, one of the safety nets of municipal bonds - bond insurance - has come under question.

Municipalities often buy insurance to guarantee the interest payments and principal on bonds in case of default. Bonds that are insured get a higher credit rating. And a higher credit rating means the municipality can pay a lower interest rate on the bonds and still entice investors.

Eileen Ambrose Recent columns

But municipal bond insurers in recent years branched out and started insuring riskier securities involving subprime mortgages. Once those mortgages blew up, insurers saw their own credit ratings downgraded. Now municipalities find that they must offer a higher rate on bonds to attract investors who are demanding better returns given new questions about the security of these investments.

That said, bond experts point out that the default rate for municipal bonds is low. In fact, they say, now might be a good time to buy the bonds because the new risk associated with them could mean more money for investors willing to take a chance.

"Municipal bonds tend to be considered a little more risky today than they have been in the past. They probably are more attractive now than in the past," says Bill Keller, director of investments for PNC Wealth Management in Maryland.

Bond yields are up. Plus, no matter who wins the White House in November, tax rates are likely to rise, adds Dan Loughran, a portfolio manager with OppenheimerFunds. "The higher the income tax rate, the more value there is to the tax exemption that muni bonds offer," he says.

Municipal bonds are usually recommended for those in the 28 percent or higher tax bracket.

If you decide municipal bonds are for you, tread carefully and do your homework. Here are some tips about different bond categories:

Individual bonds: These are suited for long-term investors willing to hold the bond until maturity, says William Larkin, fixed-income portfolio manager at Cabot Money Management in Massachusetts. At the bond's maturity - typically two to 30 years - your principal is returned.

An individual bond will pay you interest twice a year. This won't be subject to federal taxes and, if the bond is issued from within your home state, you won't pay state and local taxes on the income, either.

Because of this tax exemption, municipal bonds can offer a lower yield than a taxable bond. But which one is better for you? To find out, you need to calculate what yield a taxable bond must offer to compete with the tax-exempt municipal bond. Luckily, there are so-called tax equivalent yield calculators online that do the math in seconds.

For example, a Marylander in the 33 percent tax bracket would need a taxable bond with a yield of 6.27 percent to match a 4 percent municipal bond.

But choosing a municipal bond is more than comparing yields. And issuers don't make it easy.

They are often behind - sometimes years behind - in filing annual financial statements that can be useful to investors, according to a recent study by DPC Data, a repository for this information.

Investors should ask their advisers to check on whether a bond issue is up to date with its filings, says DPC chief executive Peter Schmitt. A lack of disclosure can hide problems.

Larkin says safety-conscious investors should consider general obligation bonds that are backed by the government issuing them, provided the community is solid.

Revenue bonds are repaid by money generated by the project being financed by the bonds. Choose revenue bonds that finance critical services such as highways, utilities, sewers and public schools, Larkin says. Avoid those that finance riskier projects such as hospitals, apartments and airports, he says.

Bond funds: If you don't want to do the homework or don't have big bucks to invest, consider a mutual fund where a professional manager selects the bonds. Bond funds can own dozens of municipal bonds from across the country, which gives you geographic diversification. Or, if you live in a high-tax area, consider a fund that invests only in municipal bonds from your state to save on state taxes.

Bond funds pay interest monthly and make it easy to reinvest the money. The funds have no maturity date, so you can lose your original investment depending on when you sell your shares.

Another alternative is an exchange-traded fund for municipal bonds, Larkin says. A municipal bond ETF will hold municipal bonds similar to those that make up a municipal bond benchmark. But unlike with a regular mutual fund, you can buy and sell your stake in the ETF throughout the day. ETFs tend to have low annual fees.