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Answer:
Dear
BuyandHolder,
There
are pros and cons attached to municipal bonds, just
as there are with any investment. However, because
most municipal bonds are rated by an independent service,
their safety is fairly easy to judge. So the answer
to your question largely depends on your tax bracket.
The
Advantages
Munis
are issued by cities, counties, states and special
agencies to finance various projects, such as schools
and highways. Their biggest plus is that the interest
paid is free from federal income tax. And, if you
buy munis issued by the state and/or local municipality
where you are a resident, their interest income will
also be free of state and/or local taxes.
Municipal
bonds pay a set rate of interest twice a year for
the life of the bond. That means if you hold your
bonds until maturity, you will get back the face value
-- $1,000 per bond. This interest income and return
of principal is certainly one way to offset the risks
typically associated with stocks.
Munis
can also provide a sound way to get a steady stream
of income. And you can select them to come due when
you know you will need an influx of cash -- perhaps
to pay college tuition or supplement your retirement
income.
Two
Disadvantages
Two
tax traps you should be aware of. One, if you buy
municipals outside the state where you are a resident,
the interest income will be subject to state income
taxes. Two, any capital gains made when you sell the
bonds is subject to federal (and most state) taxes.
Lower
Yields
Because
of their tax advantages, munis generally pay lower
rates than comparable corporate bonds of government
securities.
Interest
Rate Risk
If
you need to sell your bonds prior to maturity, you
might lose money. For example, if interest rates have
climbed since your initial purchase, your bonds could
be worth less than when you bought them. Newer bonds,
paying a higher interest rate, are more prized.
The
opposite, of course is also true. If rates have fallen,
your bonds will be worth more because they are still
paying the old, higher rate.
So
part of the answer to your question is -- buy municipal
bonds only if you can hold them until maturity.
Recall
of Bonds
Even
if you are perfectly content to hold your bonds until
maturity, you may not be able to do so. Believe it
or not, your munis could be "called in" before their
maturity date.
This
is something a great many investors are unaware of.
Not all bonds can be called -- only those that have
what is known as a "call feature." The call feature
is announced at the time the bonds are issued -- so
it is not a mystery. And, you'll get back the full
face value of the called bond, so you won't lose money.
The
call feature is usually not exercised if the current
interest rate is the same or higher than the bond's
coupon rate. But when interest rates fall below the
coupon rate, the issuer is very likely to exercise
the call feature because the municipality can now
borrow money at a lower rate.
***
Keep in mind that a bond is just a loan you make to
the issuer and the issuer would naturally prefer to
pay the lowest interest rate possible.
When
bonds are called, you face the problem of investing
the returned money at the new prevailing rate, which
is most likely lower than the rate you were receiving.
Yes
or No?
The
final point you must consider is your tax bracket.
In
general, munis are best for investors in the higher
tax brackets. There's a simple formula that will help
you determine the value of a municipal versus a corporate
bond.
(1)
Write down your tax rate as a decimal number.
(2)
Then subtract that number from the number 1.
(3)
Next divide the result into the municipal bond's yield.
Let's
say, for example, that you're in the 31% tax bracket
and you are considering a municipal bond that has
a yield of 5.5%. It would be the equivalent of a taxable
bond paying about 8%.
1
minus .31 = .69
5.5%
divided by .69 = 7.97%.
Bottom
line: You would need a taxable bond yielding at
least 8% to equal your tax-free muni with only a 5.5%
yield.
Stay
tuned...next week we'll discuss bond ratings and the
various types of municipals available.
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