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Do your municipals math

(MoneyWatch) Investors make enough mistakes to fill a book -- "Investment Mistakes Even Smart People Make" covers 77 of them. But even that list isn't exhaustive. Unfortunately, many mistakes are made not because of what people don't know, but because what they do know is wrong. Today we'll look at three of the most common mistakes investors make when buying municipal bonds.

1. Limiting purchases to bonds from your resident state

For states with income taxes, investors often automatically assume that they're best off buying local bonds because of the double tax exemption -- being exempt from both federal and local taxes in most cases. Income from bonds outside your state of residence is taxed at the state level. Limiting purchases to bonds from your home state not only creates risks that can and should be diversified, it often results in lower after-tax returns. In other words, what you want is the highest after-tax return for a given level of credit risk, not to pay the lowest amount of tax. The following example illustrates this point. On June 10, a 2021 Missouri municipal bond rated Aa1 was available to buy at a yield of 2.40. Alternatively, a Missouri resident could buy a Frisco, Texas, school district bond with the same underlying rating of Aa1 (it carried an Aaa rating due to being backed by the Texas permanent school fund) with a yield of 2.65 percent. If we adjust the Texas bond's yield for the 6 percent Missouri income tax, the after-tax yield is 2.49 percent. The result is that we improved both the yield and the credit quality.

2. Larger trades pay lower prices (earn higher rates)

While it's generally true that buyers of larger block trades (e.g., $250,000 or $500,000) pay lower prices (get higher yields), a patient buyer can often obtain lower prices (higher yields) by being willing to sacrifice the greater liquidity of a larger block and earn a liquidity premium for buying the smaller lot (e.g., $25,000 or $50,000). Broker-dealers who buy these small lots from clients don't want them sitting on their balance sheet. And since they typically have bought them at a significant discount to the market, they are willing to offer some of the spread to a buyer. Thus smaller lots can often be bought at prices that produce higher yields than on the same or comparable bond. The incremental yield can range from about 0.1 percent to as much as 0.5 percent per year. The reason this occurs is that the large buyers (mutual funds) don't play in this space, preferring to own the more liquid, large blocks.

3. If you're not in the lowest tax bracket, municipals are always better than taxables

While this is generally true for taxable accounts, it's not always true. And it can also be true for some maturities, but not others. For example, on June 10, 2013, four-year, FDIC-insured CDs were yielding 1.72 percent. AAA municipals of the same maturity were yielding 1.15 percent. For an investor in the federal tax bracket of 28 percent, assuming he or she lived in a state with no income tax, the after-tax yield on the CD was 1.24 percent. And the credit quality was better because of the FDIC insurance. It's important to understand that before deciding to buy the CD, the investor would also have to see if doing so had any other tax implications, such as the incremental taxable income pushing the investor into a higher tax bracket. The point is that you shouldn't make assumptions. You should do the math because there have been many instances when taxable bonds offered significantly higher after-tax yields than did municipals. Explore your options and look beyond your front door, your portfolio just might thank you for it.

Image courtesy of Flickr user Thewarners.

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