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Bond Basics: Municipals

The higher your tax bracket, the more you'll benefit from these bonds issued by state and local agencies.

Bonds help add diversity to your portfolio and control risk. But they can be complicated. We can help you understand the basics and make bonds work for you.

Municipal bond is a catchall name that describes the debt issues of cities and towns, states and territories, counties, local public-housing authorities, water districts, school districts, and similar governmental or quasigovernmental units.

Tax Advantages

Because the interest paid is exempt from federal income taxes and, usually, income taxes of the state in which the bond is issued, municipals can pay less interest than corporate bonds of comparable quality and still deliver the same (or better) after-tax yield. The higher your tax bracket, the more valuable this tax-exempt feature becomes.

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A simple formula can show you exactly how valuable tax-free income can be. Say you have a choice between a taxable corporate bond yielding 7% and a tax-free municipal bond yielding 5%. Which is the better deal? The answer depends on your tax bracket.

What you're looking for is the taxable equivalent to your tax-free yield. Here's how to figure it: tax-free rate/1 - federal tax bracket = taxable-equivalent yield. Say you're in the 25% federal income-tax bracket. Thus, your taxable-equivalent yield would equal the tax-free rate (5% in this example) divided by 1 minus 0.25, or 0.75. The answer: 6.67%. In this case, you're better off with the taxable bond.

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But what if you're in the 33% bracket. The equation now says to divide 5 by 0.67, which produces a taxable-equivalent yield of 7.46%. Nos, a 5% tax-free yield is better than a 7% taxable yield. That's what makes munis most attractive to people in the upper brackets. For those in the highest bracket, 35%, the taxable-equivalent yield is 7.59%.

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Also, most states don't tax the interest on bonds issued by municipal authorities within their own borders. A few states don't tax municipal-bond interest regardless of from where it comes. These breaks on your state income taxes can boost your taxable-equivalent yield significantly, especially if you live in a high-tax state.

Tax Swaps

Tax swapping is especially suited to munis and can be a valuable year-end tax-saving move. You merely sell your devalued bonds and reinvest the proceeds in bonds from a different issuer paying the higher, current rate. This gives you a capital loss for your tax return and, ignoring commissions, keeps your bond income at the same level.

Bond Ratings

Just like corporate issues, munis vary in quality according to the economic and financial soundness of the project or the creditworthiness of the issuer. Bonds considered least risky are rated AAA by S&P and Aaa by Moody's. These triple-As are considered prime investments. Next in quality comes S&P's AA, the equivalent of Moody's Aa, followed by the A rating used by both services, then BBB (Baa by Moody's), BB (Ba), and so on down the line. Bonds rated below BBB or Baa are considered speculative issues and might be risky investments over the long run. See What Bond Ratings Mean for more information.

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Whatever type of municipal bond you are considering, ask your broker for an official statement from the issuer. This document, unlike a corporate prospectus, has no standardized format. And unlike corporations, municipal-bond issuers are not required to provide regular financial information to bondholders.

Insurance

To insure bonds, an issuer or underwriter pays an insurance premium of anywhere from 0.1% to 2% of total principal and interest. In return, the insurance company agrees to pay principal and interest to bondholders if the issuer defaults.

How to Buy

You can buy munis through municipal-bond unit trusts, mutual funds or on your own. With unit trusts and mutual funds, manager's do the buying and charge a small fee. However you choose to own your muni bonds, you should shop for the highest yield consistent with the risks you're willing to take. Let's assume for a moment that each of the three options mentioned earlier -- individual bonds, unit trusts and mutual funds -- offers precisely the same yield. However, your earnings won't be the same because of costs associated with the different forms of ownership.

Individual Bonds

If you buy the bonds directly from a broker, the commission is likely to be included in the cost and reflected in the yield. Brokerage houses normally sell bonds from their own accounts, and when they raise the price to add in their sales charge, they usually recalculate the yield to reflect that additional cost.

Unit Trusts and Mutual Funds

Trusts and funds that levy sales charges, or loads, carry fees that reduce your actual return because the commission is deducted from your gross investment. If you buy $10,000 worth of a unit trust charging a typical 4.5% sales commission, what you get is $9,550 worth of bonds earning interest for you. The same thing happens with a mutual fund charging a load.

Mutual funds, including the no-loads, require the services of investment advisers to manage portfolios. For this the managers generally take 0.5% to 1% — or more — of the fund's average net asset value as a fee.

Because unit trusts normally don't trade in the market once the portfolio is set, they don't need managers. But they do require trustees and administrators, who have fees that generally amount to about 0.1% of net asset value.

Despite the fees, funds and trusts have some advantages over individual bonds. They offer instant diversity at a fraction of what it would cost an individual investor to get the same diversity. They also offer easy liquidity and convenience.

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