Municipal Bonds: How "Munis" Work and Three Low-Cost, Tax-Free Mutual Funds

David Fessler
by David Fessler, Energy & Infrastructure Strategist

Municipal Bonds: How "Munis" Work and Three Low-Cost, Tax-Free Mutual Funds

by Dave Fessler, Advisory Panelist, Investment U

Monday, October 29, 2007: Issue # 724

On the plane back from a recent business trip in Florida, I offered to help my seatmate place her bag in the overhead storage compartment. That's when I noticed an Oppenheimer business card in her bag ID window.

Turns out she's the head of the Municipal Bond Department at one of the mutual fund's largest east coast offices. She's been in the municipal bond business for nearly 30 years.

"How's the municipal bond business these days," I asked. Her answer wasn't too surprising

When big, conservative equity investors get nervous, one of the places they tend to move money into is bonds. And she said her department is seeing a noticeable increase in activity, mostly on the buy side.

Her biggest individual investor just moved $15 million out of equities and into municipal bonds.

In fact, she said municipalities are issuing bonds with greater frequency than at any time in the past 20 years. And she's right on the money

Municipal bond issuing activity is on a record pace, with over $300 billion issued so far in 2007. October's estimate is around $22 billion.

So what's going on?

U.S. infrastructure is aging, fast. And replacing and repairing it costs big money.

What's more, there's been an unprecedented migration of families to the suburbs over the last few years. So previously rural areas are scrambling to provide updated or expanded water and sewer systems and additional schools. All that money has to come from somewhere. And that's where municipal bonds come in

How Municipal Bonds Work And Why Investors Gobble Them Up

Municipal bonds (often called "munis") are issued by states, cities and counties, or agencies within those jurisdictions - school districts, water authorities, etc.

They are the most common form of debt instrument used by municipalities. Their proceeds are used for large capital projects that the issuing municipality can't pay for with funds on hand or taxes.

When municipalities issue these bonds, they receive a cash payment from the investor at the time of issuance. Just like the U.S. Treasury does.

Once issued, cities can't just sit on the money. U.S. tax laws governing municipal bonds require that they spend it within a relatively short period of time - usually 3 to 5 years.

What's in it for the bondholder?

He's given a written promise (the bond) that the issuer will repay him with interest over a 10 to 40-year period, depending on the bond. But most importantly, interest paid to bondholders is usually exempt from federal and state income taxes. In certain states, you're exempt from local income taxes, too.

This tax-exempt status is the biggest reason investors buy munis.

Of course, there are always exceptions. Some of these bonds are subject to the alternative minimum tax, and some aren't tax exempt at all.

Typically, it's the type of project the bond is issued for that affects the taxability of the interest. Generally speaking, projects funded in the public interest are tax-exempt.

How to Buy "Munis"

There are several ways to invest in municipal bonds.

Most full-service brokers can purchase them for you. You can also buy them through many online brokers. But buying shares in a municipal bond fund is much easier. You get instant diversification, too.

Vanguard's Long-Term Tax-Exempt Bond Fund (MUTF: VWLTX) yields 4.05% right now. It's averaged a total return of 6.31% a year since 1977. And again, that's tax free. The minimum initial investment is $3,000. And, of course, you get Vanguard's ultra low fees - a miniscule 0.16%.

Take a look at Vanguard's Short-Term Tax-Exempt Bond Fund (MUTF:VWSTX), too. And the Intermediate-Term Tax-Exempt Bond Fund (MUTF: VWITX).

All three funds invest in hundreds of investment-grade, tax-free bonds.

In the long run, owning bonds is key to your overall return - as is keeping your investment costs to a minimum and your tax burden low. Picking up shares of funds like these accomplishes all three objectives.

Good Investing,

Dave

Today's Investment U Crib Sheet: How Do Bond Ratings Work?

Stocks, bonds, real estate. All investments, by nature, carry a degree of risk. Even U.S. Treasuries aren't a sure bet. (If the U.S. government can't pay you, it will just print more money, and depreciate your dollars.)So how do you know how risky a bond is?

Standard & Poor's and Moody's are two of the biggest independent rating agencies. They specialize in evaluating the financial strength of bond issuers, then determine the company, agency or municipality's ability to repay its investors.

Here are their rating systems:

Standard & Poor's

Description Moody's
AAA Least Risk - High Grade Aaa
AA High Grade Aa
A Upper Medium Grade A
BBB Lower Medium Grade Bbb
BB Non-Investment Grade Bb
B Speculative B
CCC Highly Speculative Ccc
CC Substantial Risk Cc
C Poor Standing C
D Default D

Of course, bonds alone won't make you rich. The best portfolios blend several non-correlated asset classes. That includes stocks, even if you're already enjoying retirement; we have to make our money last longer than ever these days.

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