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Muni Bonds: Best Investment for Rising Taxes

With interest rates historically low and income taxes poised to rise — for wealthy investors, at least — municipal bonds have been attracting lots of interest of late. And lots of doomsday talk: Prices will tank as rates rise, the fear goes, and state governments that issue the bonds are on the verge of an economic Armageddon.

Those are serious risks to be sure, but consider the rewards: For investors in the 28 percent tax bracket (taxable income over $137,300 for married couples filing jointly), the 3.1 percent yield on the highest-quality 10-year muni bond is equivalent to earning a taxable 4.3 percent. A comparable Treasury bond pays 3.8 percent. Factor in potential tax hikes by 2011 and the coming levy on investment income for high earners (part of health-care reform), and tax-free income is even more valuable.

Better yet, certain state bonds are especially lucrative today. With a New York muni fund, for example, investors can earn the equivalent of 5.9 percent. (To get the taxable-equivalent yield of any municipal bond, use this calculator.) And while high yields hint at the budget problems that are a cause of so much concern, even single-state municipal bond funds can have a role as part of a diversified portfolio. Just be sure to protect yourself.

How to Cut Your Risk

What has bond market observers worried is the shaky financial condition of so many cities and states. In the wake of the massive slowdown in real estate and retail sales — both big tax generators — state budget deficits are expected to total $256 billion for the 2009 to 2011 fiscal years, according to the National Association of State Budget Officers. It’s no wonder Jim Chanos, the hedge fund manager best known for predicting the Enron debacle, fears a wave of bond defaults by cash-strapped municipalities.

Yet plenty of savvy investors are undeterred. “Yes, there are financial difficulties for some municipalities ahead, but the worst is behind us,” says Lew Altfest, a financial advisor in New York City. So far, the wave of defaults hasn’t materialized. In 2009, fewer than 200 of 50,000 municipal bonds went bad. “Defaults remain extremely rare,” says Justin Hoogendoorn, managing director in the strategic analytics group at BMO Capital Markets in Chicago.

What’s more, the typical municipal bond fund holds hundreds of securities — if an issuer defaults, the fund should be able to absorb the blow. Follow these four steps when picking a fund:

1. Favor quality above all

Given the risks, stick with a fund with an average credit quality of single-A or better (a stat you can find in the portfolio section of One such standout is the USAA Tax-Exempt Intermediate-Term Bond Fund (USATX), which has an average credit quality of A and recent yield of 4.5 percent. For an even higher quality portfolio, consider the AA-rated Vanguard Intermediate-Term Tax-Exempt Bond Fund (VWITX), a favorite of many financial advisors and a top Morningstar pick. (Higher quality means a more modest payout — this fund yields 3.8 percent.)

Another gauge of safety is the type of bonds the fund holds (also available at Morningstar). General obligation bonds — which are backed by the taxing power of the issuer, rather than revenues from a single source — are considered particularly safe. The Vanguard Intermediate-Term Tax-Exempt Bond Fund, for example, has a sizable 23 percent stake in GO bonds.

Also considered especially stable today: bonds used to finance services such as utilities, transportation, and higher education. “Even in the worst of economic times, people tend to pay their water and sewer bills,” says Michael Joyce, a financial advisor at JoycePayne Partners in Richmond, Va.

2. Don’t go long-term

With interest rates at historic lows, you’d be hard pressed to find a forecaster who doesn’t think they are heading up soon. In face, some believe the bond market is the latest investment bubble poised to burst.

For bond investors, rising rates will mean falling prices. The best defense: short-term municipal bond funds, which pay less but will also drop less as rates rise.

The way to tell how much interest rate risk you’re taking is to look at a measure called duration (it’ll be prominently listed on any fund fact sheet). A fund with a duration of two years would lose 2 percent of its value if interest rates rose one percentage point. For a fund that will hold up well in a rising-rate environment, Kirk Kinder, a certified financial planner at PicketFence Financial, favors Vanguard’s Limited-Term Municipal Bond Fund (VMLTX), which has a duration of 2.5 years and a recent yield of 2.51 percent.

Keep in mind that rising rates aren’t all bad, especially if you’re a long-term investor. Yes, the value of your fund will take a temporary hit. But as those lower-yielding bonds mature, the manager will buy higher-yielding bonds. And higher yields are even more valuable for high-income investors because of the tax break.

3. Hold down expenses

Because bond returns can be razor thin, low expenses are the surest way to boost your returns. That’s why Altfest likes Vanguard’s state and national bond funds, which feature below-average expenses. For example, the Vanguard Intermediate-Term Tax Exempt Bond Fund has an expense ratio of 0.20 percent, vs. 1.04 percent for the average fund.

Exchange-traded funds (ETFs) offer investors another way to keep costs low. Matthew McCall, editor of the ETF Bulletin, favors the iShares S&P National AMT-free Municipal Bond ETF (MUB), the largest muni bond ETF. Its annual expenses are just 0.25 percent.

4. Shop locally

Bonds issued by your state are free of local as well as federal taxes, making single-state muni bond funds especially attractive for high earners in high-tax states. For a New Yorker in the 28 percent federal tax bracket, the 4 percent yield on Vanguard New York Long-Term Tax-Exempt (VNYTX) is the equivalent of earning a taxable 5.9 percent.

But is it safe to buy a single-state fund when local governments are struggling with deteriorating finances? California, fresh off its 2009 fiscal crisis, is a particular concern right now. Still, James Stehr, a financial advisor in Alameda, Calif., likes Fidelity California Short-Intermediate Tax Free Bond Fund (FCSTX). “I must rely on the fund manager to steer clear ofbad-risk localities,” he says.“With the red light flashing for almost a year now, that shouldn't be too difficult.”

Many experts believe that these funds have Uncle Sam’s implicit backing. “The main reason I don't fear [state] munis is I really don't see a situation where the federal government wouldn't step in to help,” says Kinder.

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