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Course 309


Driving a Jaguar. Shopping at Neiman Marcus. Investing in municipal bonds.

These activities may seem exclusive to the rich and famous, but you don't need to be part of the elite to invest in municipal bonds. Investors in the highest tax bracket may profit most from municipal bonds' tax-exempt status, but investors in the lower tax brackets can benefit, too.

In this lesson, we'll find out how municipal bonds work, and why they are one of the last great tax breaks for investors. We'll then share Morningstar's hints for selecting a good municipal-bond fund.

What's a Muni?

States, cities, municipalities, and county governments can all issue municipal debt, or muni bonds, to raise money. They use the proceeds to improve roads, refurbish schools, or even build sports complexes. The bonds are usually rated by a major rating agency, such as Standard & Poor's or Moody's, based on the quality of the issuer.

Unlike income from bonds issued by corporations or the federal government, income generated by municipal bonds is exempt from federal and sometimes state income taxes. So when examining a municipal bond's yield, you must take the implicit tax advantage into account.

Let's take an example. Say you're an investor in the 25% tax bracket. You want to know which investment offers you a better yield: a corporate-bond fund yielding 7% or a muni-bond fund yielding 6%. After taxes, the muni fund is the higher yielding investment: Take 25% in taxes off the corporate-bond fund's 7% yield, and you're left with an aftertax yield of just more than 5%.

Muni-Fund Considerations

As you can see, municipal-bond funds can certainly be a compelling choice for the bond portion of your portfolio. If you decide that munis make sense for you, consider the following when searching for a suitable muni fund. (You can find much of this information on a Fund Report, in its shareholder report or prospectus, or on the fund family's Web site.)

Intermediate-Term Durations. As with most bond funds, a municipal-bond fund's value rises and falls depending on interest-rate changes. To determine a fund's interest-rate risk, check its duration. A long duration usually means greater potential for short-term gains and losses.

In December 2010, Vanguard Long-Term Tax Exempt's (VWLTX) duration was around 7 compared with Thornburg Limited-Term Municipal National's (LTMFX) duration of 4. No wonder the Vanguard fund lost much more than the Thornburg fund (-1.56% versus 0.48%) in December 2010 through February 2011 as interest rates rose. But when rates were more subdued in 2009, the Vanguard fund's longer-duration portfolio outgained the Thornburg fund's, 14% to 8.5%.

Our suggestion: Choose the happy medium. The intermediate-term and long-term municipal-bond fund categories have returned roughly the same (4.7% annualized) over the trailing 10 years through 2010. But the intermediate-term muni category has had less volatility. As with most bond funds, a municipal-bond fund's value rises and falls depending on interest-rate changes. To determine a fund's interest-rate risk, check its duration. A long duration usually means greater potential for short-term gains and losses.

Average Quality Some municipal-bond funds are vulnerable to credit problems and bond defaults. (That is, the issuers of the bonds they own could fail to pay up on their obligations.) Some aren't.

Baird Intermediate Muni Bond Fund (BMBIX), for example, focuses on very high-quality munis, with over 70% of the portfolio allocated to AAA-rated bonds as of March 2011. Such bonds are very unlikely to face default, but they are also highly sensitive to interest-rate movements, and generally yield less than lower-quality bonds. On the other end of the credit spectrum lies Franklin High Yield Tax-Free Income (FRHIX), which invests heavily in lower-rated, higher-yielding munis.

For most of the 1990s, the strong economy masked the risks of high-yield municipal bonds. The average high-yield muni fund returned about 3% more annually than the average high-quality offering during the decade ending Dec. 31, 1999. Roles reversed in the 2000s, though, as the economy has slowed and more municipalities threaten to default on their debts.

Here too, we recommend a middle-of-the-road approach: Favor funds with average credit qualities of AA. They have enough high-quality bonds to skirt most credit scares but are still flexible enough to snap up higher-yielding, lower-rated issues.

Know Your State's Tax Rate. Some municipal-bond funds invest all over the country, while others focus on a single state. National funds offer geographical diversification and can seize opportunities from New York to New Mexico.

Single-state funds, meanwhile, provide residents of some states with income that's exempt from both federal and state taxes. (National muni funds only give you the federal tax break.) A Californian doesn't pay the state income tax on the income from a California muni fund, and a resident of the Bay State avoids the Massachusetts tax on income from a Massachusetts fund.

Choose a single-state fund if you live in a high-tax state. Otherwise, go national for the diversification benefits.

Seek Low Costs. Costs are important for all bond funds, but especially for municipal-bond funds. In any given year, the difference between the highest- and lowest-returning muni funds can be just a few percentage points. A small cost advantage therefore goes a long way. Invest in a muni fund with an expense ratio of less than 1%.

Avoid AMT, if Need Be. You can still owe taxes on the income of municipal-bond funds if you're exposed to the Alternative Minimum Tax (AMT) and the fund you own holds bonds subject to this tax. Fund managers buy bonds subject to the AMT because they tend to yield more than non-AMT bonds.

If you're concerned about the AMT, choose a muni fund that avoids bonds subject to the tax, such as T. Rowe Price Tax-Free Income (PRTAX). Fund family websites and prospectuses should spell out each fund's AMT policy.

Quiz 309
There is only one correct answer to each question.

1 Which is the higher-yielding bond fund after taxes for someone in the 28% tax bracket: a corporate bond fund yielding 7.5% or a national municipal-bond fund yielding 6.0%?
a. The corporate bond fund.
b. The municipal-bond fund.
c. Their yields are the same after taxes.
2 Who issues municipal bonds?
a. Corporations.
b. The U.S. Treasury.
c. Municipalities, counties, or special projects.
3 Intermediate-term municipal bonds funds have:
a. Returned just as much as long-term muni-bond funds, with a lot more risk.
b. Returned far less than long-term muni-bond funds, with a lot less risk.
c. Returned nearly as much as long-term muni-bond funds, with less risk.
4 Assuming three municipal bonds mature at the same point in the future, which one likely yields the most?
a. The low-quality bond.
b. The medium-quality bond.
c. The high-quality bond.
5 According to Morningstar, which is the best type of municipal-bond fund for most investors?
a. Fund A, a long-term fund with an average credit quality of AAA and an expense ratio of 1.15%.
b. Fund B, an intermediate-term fund with an average credit quality of B and an expense ratio of 1.0%.
c. Fund C, an intermediate-term fund with an average credit quality of AA and an expense ratio of 0.75%.
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