Municipal bonds yield better returns

In low-rate environmen­t, investors can wade into tax-free income stream


If you’re an investor looking for yield, you may as well smash a mirror, walk behind a litter of black cats, and buy an apple from a witch. What the heck. You won’t have any luck today, anyway.

You can get somewhat higher after-tax yields investing in municipal bonds. In fact, only someone under a curse would buy Treasury securities instead of munis. Just be aware that some day rates will rise, which could hurt your muni holdings.

Municipal bonds are long-term IOUS issued by states, cities and other municipal entities. Their biggest charm: muni interest is free from federal taxes. If you buy a muni issued by your state, interest is free from state taxes, too.

The bellwether 10-year Treasury note yields 2%. A 10-year high-quality muni yields 2.06%. It doesn’t matter what tax bracket you’re in: A muni will get more yield. “You’re getting the tax exemption for free,” says Dan Loughran, senior portfolio manager of Oppenheime­rFunds’ Rochester municipal investment team.

Munis typically yield 10% to 15% less than Treasuries. If munis yield more than Treasuries, it’s usually a lucky day to buy them.

Why the higher yield? The answer may have more to do with Treasuries than munis. When the world looks risky, investors flock to Treasury securities, widely regarded as the safest investment on the planet. Demand for Treasuries has pushed yields down, making munis look attractive in comparison.

The tax exemption for munis really sweetens the deal. If you’re in the 35% federal tax bracket and want to earn 2.06% after taxes, you’d have to find a taxable bond yielding 3.2%.

If you live in a high-tax state, then munis from your state can be exceptiona­l. A nine-year California muni bond offered Thursday was yielding 2.68%. Let’s say you were in California’s maximum 10.3% tax bracket and the U.S. 35% tax bracket. To earn 2.68% after taxes, you’d need to find a bond yielding 4.9%.

Rates aren’t the only considerat­ion. California’s bond has a higher yield than most because, well, it’s California. The state has budget issues, to put it mildly, which is why it’s rated A1 by Moody’s — a decent rating, but not the top one.

The greater the likelihood of default, the higher the yield investors demand from issuers. And states remain under considerab­le financial pressure, thanks to the sluggish economy.

Despite a widely publicized prediction of municipal bond collapse from banking analyst Meredith Whitney in late 2010, munis have been remarkably robust. Just 11 muni issuers have defaulted in the past two years, says Moody’s, which rates 17,000 muni bonds.

If your main concern is income, and you can stand the risk that your fund’s share price can go down, a muni bond fund is worth investigat­ing. If you can stand a bit more risk, then a high-yield muni fund is even more attractive. Other options: -Closed- end muni funds. These are a peculiar type of fund that trades on stock exchanges, but only issue a set number of shares. So their share prices are sometimes less (or more) than the value of the securities they hold. For example, the price for Invesco Value Municipal Securities fund (ticker: IMS) was $14.30 Wednesday. But the value of its holdings was $14.98, says the Closed-end Fund Associatio­n. Essentiall­y, you get a muni bond portfolio at a 4.5% discount to its actual value.

-Exchange traded muni funds. Like closed-end funds, these trade on stock exchanges, but a special pricing mechanism usually closes the premium or discount dramatical­ly. Market Vectors Intermedia­te Term muni (ITM) is one good choice.

-Individ-al bonds. Many discount brokerages will now let you buy individual munis. If you hold them to maturity, you run little risk of loss. In general, though, it’s more cost-effective to buy through a fund.

A final warning: Bond prices fall when interest rates rise. If you’re investing in a fund, your share price will fall when rates rise again. And it’s a good bet that rates will rise. If you can’t stand any risk, stick with a bank CD or a Treasury security.

Finding a decent yield isn’t as lucky as, say, missing the maiden voyage of the Titanic. But if you can stand some risk, you can save on taxes and get a reasonable yield. And that should be enough for anybody.

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