RSM Resources

Nervous fits about inflation and energy instability have roiled the stock market for much of the year, flustering many growth-hungry investors. At the same time, those seeking income from longer-term corporate and government bonds have seen steadily rising interest rates flatten their returns.

To help navigate the pitfalls of such choppy investment waters, experts say owners and executives of midsized businesses should consider adding municipal bonds to their overall asset-allocation plans.

"Municipal bonds aren’t a way to get rich, but with careful planning, they can be a way to stay rich," says David Scott, a finance professor at Valdosta State University in Georgia and author of more than a dozen personal finance books,including Investing in Bonds. "Municipals are particularly appealing to people who live in states with high income taxes and especially advantageous for investors in higher federal income-tax brackets."

State and local governments issue municipal bonds (or "munis") most often to finance major public works projects. General obligation (GO) munis, which governments often use to finance infrastructure projects such as roads, bridges and schools, are backed by the issuer’s taxing authority, making them a conservative bet for reliable returns. Revenue bonds, however, are repaid from the income generated by a finished construction project — such as a stadium or convention center. While riskier than GO bonds, the rate of default for high-quality revenue bonds is low.

As an investment, municipal bonds generally deliver lower returns than comparable corporate or government notes in exchange for significant tax benefits. While all interest income that municipals generate is exempt from federal taxes,investors who live in the state where the bond was issued don’t pay state income tax on the returns either. In certain cases, an investor living in a city and state with high income-tax rates can receive "triple tax-free" benefits by purchasing municipal bonds for a project in their hometown.

While corporate and government bonds outperformed municipals by as much as two percentage points in the mid-1990s, that gap has narrowed considerably in recent years. According to bond indices that Lehman Brothers monitors, municipal bonds delivered average returns of 3.51 percent in 2005. That’s well above the aggregate performance in the same year for taxable corporate bonds (2.43 percent) and U.S. government treasuries (2.79 percent).

A taxing question

Before making a decision to invest in municipals, take a closer look at your overall tax picture. For example, if you live in a state with no income tax, the benefit of purchasing this type of bond greatly diminishes.And, even though the interest income on municipal bonds isn’t taxable, Uncle Sam still requires you to report it on your Form 1040.

Experts generally agree that calculating a municipal bond’s tax-equivalent yield (or TEY) is the best way to determine its true benefit to an individual investor. In short, the TEY is a way to measure the rate of return needed from a taxable bond to make it a better choice than a tax-exempt municipal. Here’s how it works:

Assume you are in the 28 percent tax bracket and are considering buying a 15-year, AAA-rated municipal bond paying 4.4 percent. To determine the TEY, subtract your tax rate from one (0.72) and divide that number into the municipal bond’s yield. In this example, the TEY shows that a taxable bond would need to pay at least 6.11 percent to match the benefit of a comparable municipal bond. On the other hand, investors in the 15 percent tax bracket would need to find a taxable bond paying only 5.18 percent to achieve the same results.

A common strategy forgetting the maximum benefit from bond investments is to build a ladder, which helps diversify maturities and ease reinvestment decisions. For example, assume you buy three bonds maturing in five years, 10 years and 15 years. By using a bond-ladder approach, Scott says, you have a simple tool to determine future investment moves.

"Right now,the rate of inflation is running a bit over 3 percent, and yields on long-term municipal bonds are just over 4 percent," he said. "Since there’s a real possibility you will soon get a better yield on money-market accounts than on longer-term bonds, people using a bond-ladder strategy will be well-positioned to evaluate if reinvestment is the right strategy at that time."

Are you ready to consider municipal bonds as part of your overall wealth management strategy? If so, remember the following tips.

Beware of unusually high yields. As a general rule, Scott recommends that investors stick with municipals that have credit ratings of "A" or higher. While lower-rated bonds can offer higher quoted returns, the increased risk may not be worth the trade-off.

"The old saying ’if it sounds too good to be true’ applies here," he says. "A quoted yield out of line with averages in that peer group generally means there’s an underlying problem, such as a possibility the note will be called before maturity, or a higher-than-promoted level of risk."

Watch the timeline. In the current environment, longer-term bond investments are not wise plays. Scott advises prospective municipal bond investors to buy high-quality, short- to medium-duration notes that mature in no more than 15 years.

Avoid mixing municipals with retirement plans. Because of their tax-exempt status, Scott says municipal bonds are a bad choice for tax-deferred 401(k) or 403(b) retirement plans, because investors would pay taxes on any amounts they withdraw.

Do your homework. For the do-it-yourself investor, a number of sound information and research resources are available from services such as Morningstar or ValueLine. These tools can provide overviews of a bond fund’s management, objectives and costs.

Seek professional advice. As with all investments, municipal bonds are not perfect for every situation. By working with a professional advisor, you can tap into a wealth of industry experience and training, and receive objective feedback on whether municipals are a sound fit for your personal investment goals and needs.