investing

Income Investing: Municipal Bonds to Earn 1% - 3%

Don't let a few headlines about jursidictions with financial woes scare you away from these tax-exmpt yields.

On the surface, bonds issued by state and local governments don’t pack much of a yield punch. But Uncle Sam generally doesn’t tax muni interest, which may be exempt from state taxes, too. Those breaks add up, especially for investors in the higher tax brackets. A 2% yield from a muni bond translates to a taxable yield of 3.3% for taxpayers in the top, 39.6% bracket. Add in a 3.8% Medicare levy on high-income earners, and the taxable-equivalent yield of 2% tax-free climbs to 3.5%.

Earnings for All

Even after a strong two-year run—with high-quality tax-free bonds returning an average of 9.1% in 2014 and 3.3% in 2015—the market still looks “a little cheap,” says Hugh McGuirk, head of municipal investments at T. Rowe Price. After taxes, muni yields exceed those of Treasury bonds with similar maturities. And despite headlines about states and other jurisdictions with shaky finances—notably Illinois and Puerto Rico—almost all muni issuers honor their obligations. Individual muni bonds default at a rate of less than 0.2% a year, which is well below the default rate for high-quality corporate bonds.

Risks to your money. Credit-rating cuts could send bond prices spiraling. States with a “negative” ratings outlook now include Alaska, Louisiana, New Jersey and Pennsylvania, according to Moody’s. Rising interest rates would lower the value of existing bonds and depress share prices of muni funds (though higher interest payments would offset the losses over time). Inflation may eat away at the value of your principal and interest payments.

Hire a pro. Residents of high-tax states should buy funds that hold bonds issued by their state or local government. Two top mutual fund choices for California and New York residents are Vanguard California Long-Term Tax-Exempt (symbol VCITX, yield 1.9%) and Vanguard New York Long-Term Tax Exempt (VNYTX, 1.8%). If state taxes aren’t a concern, go for iShares National Muni Bond ETF (MUB, $111, 1.5%), an exchange-traded fund that holds hundreds of munis issued by state and local governments across the country. T. Rowe Price Tax-Free High Yield (PRFHX, 2.8%) pays substantially more, but the mutual fund’s bonds have lower credit ratings and are more susceptible to default or a slump in price if their issuers run into financial troubles. (All prices and returns are as of March 31.)

Do it yourself. Individual bonds can be a good bet if you hold them to maturity. But you should take this route only if you can plow in at least $50,000, spread over several bonds, in order to stay well diversified. A San Diego Redevelopment Agency bond, rated double-A, recently yielded 2.5% to maturity in 2027. And a Chicago O’Hare International Airport revenue bond, rated single-A, yielded 3.4% to maturity in 2031. Neither bond can be called, or redeemed, until 2025, and their issuers should generate enough steady revenue to meet their interest payments until the debt comes due, says Dusty Self, comanager of the RidgeWorth Seix Short-Term Municipal Bond Fund.

Next: Investment-Grade Bonds to Earn 3% - 5%

Most Popular

The 15 Best Stocks for the Rest of 2022
stocks to buy

The 15 Best Stocks for the Rest of 2022

The lesson of the past two years: Be ready for anything. Our 15 best stocks to buy for the rest of 2022 reflect several possible outcomes for the seco…
June 21, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
The Best Bank for You, 2022
Making Your Money Last

The Best Bank for You, 2022

Check out our list of the best candidates for your next financial institution based on interest rates, fees and other features.
June 23, 2022

Recommended

Move Over ETFs: Direct Indexing Is an Investment Strategy Worth Paying Attention to
investing

Move Over ETFs: Direct Indexing Is an Investment Strategy Worth Paying Attention to

More flexibility, more control, the potential for higher returns and tax-reducing strategies: With pros like that, could direct indexing be right for …
June 25, 2022
33 States with No Estate Taxes or Inheritance Taxes
retirement

33 States with No Estate Taxes or Inheritance Taxes

Even with the federal exemption from death taxes raised, retirees should pay more attention to estate taxes and inheritance taxes levied by states.
June 23, 2022
Best Banks for Higher-Net-Worth Clients
wealth management

Best Banks for Higher-Net-Worth Clients

Those who can meet high minimum-balance requirements at these banks get abundant account freebies and extras ranging from financial advice to event ac…
June 23, 2022
Smart Investing in a Bear Market
investing

Smart Investing in a Bear Market

Here's how to make the most of today’s dicey market.
June 22, 2022