As 2008 drew to a close, you may have found yourself reviewing your investment strategy to determine if you made the right moves to help you achieve your financial goals. And one topic you may well focus on is tax-advantaged investing.
Did you do all you could in this area? If not, you might want to consider a popular, but often misunderstood, investment: municipal bonds. And right now, these types of bonds may be more appealing than they've been in many years.
Essentially, a municipal bond is a debt security issued by a state, municipality or county to finance its capital expenditures, such as bridges, highways or schools. The interest you receive from municipal bonds is exempt from federal taxes and from most state and local taxes, especially if you live in the state in which the bond is issued. Nonetheless, if you're like many people, you might dismiss municipal bonds as conservative investments that usually offer lower yields than taxable Treasury or corporate bonds. (The yield is the return you will receive on your bond if you hold it until maturity.)
But what you may not realize is that if you are in one of the upper tax brackets, the tax savings you receive from your municipal bonds may be enough to provide you with a higher yield than you'd get from a comparable Treasury or corporate bond.
Furthermore, in recent months, we've seen something that rarely occurs: municipal bonds yielding as much as, or more than, Treasury bonds - even without taking the tax benefits into account. Why has this happened? For a variety of circumstances, the market has become somewhat "glutted" with municipal bonds; this oversupply has led to lower prices. And bond prices are inversely related to yields, so the drop in municipal bond prices has led to the higher yields.
Thus far, we've seen that today's municipal bonds feature tax advantages, low prices and relatively high yields. Yet like all investments, municipal bonds do carry some types of risk, including the following:
Credit risk: During difficult economic times, municipalities may be strapped for cash and have trouble meeting their financial obligations - such as scheduled interest payments on their bonds. It's a good idea to invest in a municipal bond whose issuer is considered highly creditworthy, as determined by the ratings it receives from an independent rating agency, such as Moody's or Standard & Poor's.
Call risk: When market interest rates are falling, a municipality may want to buy back - or "call" - its bonds so that it can reissue new ones at the lower rates. Obviously, if your bond is called, your income stream will be disrupted. That's why you may want to look for municipal bonds that offer call protection - a period of time during which the issuer cannot call the bond.
One final note of caution: Some municipal bonds are subject to the alternative minimum tax, so, before investing in a muni, consult with your tax adviser.
Once you understand these risks and take the steps we've suggested to address them, you may find that municipal bonds can play a valuable role in your portfolio, so give them some consideration.