Last Updated: July 21, 2009
Americans in search of income have turned their attention to municipal bonds. Such investments typically offer tax-free income and safety. However, financial planners suggest that before buying such securities — be it in the form of individual securities, open or closed-end bond funds, or exchange-traded funds — you should consider the following:
- Make sure you know what's going on in the municipal bond market. The municipal bond market is in the midst of great change and scrutiny. The U.S. Securities and Exchange Commission (SEC) has proposed rules to improve the availability of timely and important information to municipal securities investors and other market participants. "Currently, there is a disparity between the level of information available to investors in municipal securities versus information available to investors in corporate securities," SEC Chairwoman Mary Schapiro said in a recent release. Learn more at SEC.gov.
- Get smart about the risks related to municipal bonds. The Financial Industry Regulatory Authority (FINRA) Investor Education Foundation recently released a new alert called "Municipal Bonds —Staying on the Safe Side of the Street in Rough Times" as well as the Muni-Bond Investor Checklist. According to FINRA, muni-bonds have historically been considered relatively low-risk investments, but you should be aware that they carry certain risk, including the possibility of defaults. Learn more at FINRA.org.
- Consider your overall portfolio. "I believe it would be prudent for an investor to evaluate the composition of his or her entire portfolio from a tax perspective in conjunction with an overall asset allocation target," said FPA member John Kilroy, CPA, CFP®. "It may be that the investor would need to consider placing tax inefficient assets, such as taxable bonds or bond funds, inside tax deferred accounts."
- Consider your tax situation. "If the above process results in a need for bonds outside tax deferred accounts, then it may be reasonable for the investor to project a current marginal tax bracket and overall projected current year income tax," said Kilroy. "This projection could be done assuming taxable bond income in one case and tax-exempt income in another case. The projected tax differential in the two cases should then be compared with the projected yield difference between the taxable bond or bond fund and its municipal counterpart. It may sound like a lot of work, but Kilroy said: "I think it's essential before the investor begins to evaluate specific bond options, especially if the investor is in an unusual tax year due to a one time or infrequent income or deduction, or is subject or potentially subject to alternative minimum tax (AMT)."
- Consider municipal bond funds for all but the largest portfolios. "Most investors, I believe, would be well-served with low cost, high quality mutual funds rather than individual issues," said Kilroy. "The benefits gained through cost savings would be hard to replicate with any other approach. Individual bond laddering probably is out of the reach of most investors and typically requires additional cost, time and effort."
- Check out the underlying credit of the municipalities in which you invest. If you do buy individual municipal bonds, FPA member, Leslie Beck, CFP®, of Beck Investment Management suggests that you evaluate the credit rating of the municipalities in which you invest. Generally, a credit rating suggests how risky an investment might be. The better the rating, the less likely the municipality will default on its obligation. There are three major rating agencies for municipal bonds: Moody's Investors Service, Standard & Poor's, and Fitch Ratings. Beck recommends you work with a financial planner when purchasing individual municipal bonds. A financial planner knows, for interest, what sort of commission bond brokers might be earning to buy and sell municipal bonds. Find a financial planner.
- Watch interest rates. As with most bonds, the value of such investments move in the opposite direction of interest rates. So be sure to watch interest rates. The value of your bonds could decline if interest rates rise. Likewise, the value of such bonds could rise if interest rates fall.