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The Pros and Cons of Municipal Bonds

Fixed-income investors have spent years in the desert, enduring record low yields and the constant threat of losing principal if interest rates rise.

But a band of true believers continues to stick with municipal bonds, preaching the virtues of tax-exempt earnings, high credit quality, diversification and insulation from that worrisome interest-rate risk.

"Muni bonds provide attractive after-tax income and, more importantly, help reduce overall portfolio volatility during times of market stress," says planner Anthony D. Criscuolo of Palisades Hudson Financial Group in Fort Lauderdale, Florida. "Muni bonds are generally considered a safe-haven investment because of their historically low default rate."

Highly rated, long-term munis aren't likely to make you rich, with many 30-year issues yielding 3 percent or less, says finance professor Gary Witt of Syracuse University's Whitman School of Management, blaming the market's belief that interest rates will remain low for some time. But he notes that munis are still a good alternative to bank savings paying less than 1 percent.

[Read: 4 Facts Investors Should Know About Bonds.]

"We may well be at the beginning of a multi-decade period of low growth and low interest rates," Witt says. "If so, municipal bonds with a 2.5 percent after-tax return will be as good as it gets."

Municipal bonds are sold by state or local governments to pay for projects that benefit the public, such as schools, sewer systems and roads, with payments to investors guaranteed by the issuer's taxing authority. Some riskier ones are used to support non-profit entities like colleges and hospitals, with income less certain.

Because munis fund projects for the public, interest earnings are exempt from federal taxation, and also from state and local tax if the investor lives in the state where the bonds were issued. Profits from rising muni bond prices are subject to long- or short-term capital gains tax.

The exemption on interest earnings allows muni issuers to market bonds with lower yields than investors can earn on taxable bonds with similar maturities, making munis an inexpensive form of government borrowing. For apples-to-apples comparisons, investors must do some arithmetic to convert tax-free yield to a taxable equivalent from a corporate or Treasury bond. For an investor in the 25 percent tax bracket, for instance, a muni yielding 2 percent competes with a taxable bond yielding 2.6 percent, because a 25 percent tax would reduce a 2.6 percent yield to 2 percent.

The higher the investor's tax bracket the greater the benefit from tax exemption.

"We love munis for clients in a 25 percent marginal tax bracket or higher," says Steven W. Kaye, president of AEPG Wealth Strategies in Warren, New Jersey. Clients in the highest tax brackets -- generally around 40 percent -- are often advised to make munis their largest holding, he says.

While investors may be able to find corporate bonds that pay more than munis, even on an after-tax basis, munis are typically safer, Kaye says. A rise in prevailing interest rates, which makes older, stingier bonds less marketable, does less damage to a muni than to a taxable bond, he notes.

[Read: Why Bond Yields May Be Bad For a Long Time.]

Because of the issuers' taxing authority, munis also have a "credit cushion," he adds. That means less risk of losing value over worries the issuer won't make the interest and principal payments promised.

Though wealthy investors benefit most from tax exemption, munis can serve small investors who need income and want to diversify their holdings, Criscuolo says.

Citing a study from Charles Schwab, he says munis rated BBB have a 10-year default rate of only 0.32 percent, compared to 4.61 percent for corporate bonds with the same rating.

"(Munis) have received some negative press lately with high profile defaults by Detroit and Puerto Rico. But looking at average historical default rates, it is clear why munis are viewed as a safe-haven," Criscuolo says.

For the time being he recommends munis with shorter maturities to minimize interest rate risk. Bonds with long maturities can plunge in value when prevailing rates rise, because investors can be stuck with below-market yields for years.

"Because interest rates are at historical lows, they really have nowhere to go but higher," Criscuolo says. "Rates are not likely to skyrocket anytime soon, but with rates so low, it is wise to focus on shorter-duration bonds now." Duration, expressed in years, tells how much a bond's price will rise or fall with every one percentage-point move in interest rates. A five-year duration means a bond can lose 5 percent with a one-point rise in rates.

Investors attracted to individual municipal bonds also need to consider "call risk," Witt says. That's when the issuer decides to repay the principal early, depriving investors of the interest earnings they had expected, and typically forcing them to reinvest in newer bonds with lower yields. Like mortgage refinancings, calls rise when interest rates fall, as muni issues sell new bonds to pay off older ones.

Today, Witt says, an investor might buy a new 30-year AA-rated bond yielding 2.5 percent, or one issued a few years ago that pays 5 percent. But one would pay a heavy premium --a price above face value -- for the older bond. If it were called, the combination of premium paid and lost interest earnings would reduce the effective yield to below 2 percent, Witt cautions. (A bond priced below its face value is selling at a discount.)

"Investors should know both the yield to maturity and the yield to call," Witt says. "The smaller of these two yields is a better guide to the actual return."

Investors can buy individual munis through brokers or an online market place, and Jim Grandinetti, head of portfolio management at Gurtin Municipal Bond Management in Solana Beach, California, says it is possible for diligent shoppers to find bargains because the enormous muni market gets less scrutiny than the stock market.

But because so many factors must be weighed to find a good muni, many advisors say small investors should use mutual funds, to let the pros do the choosing.

"Funds and ETFs can provide much needed liquidity in times of market stress," Kaye says. "I find that most investors do not understand how premiums and discounts work. Additionally, I find most investors don't have a clue as to how mark-ups work. These factors should point less sophisticated investors to funds and ETFs."

Markups are extra charges added by the broker when a muni is purchased, like a margin added by a retailer.

Because fund mangers trade in large lots, they get better deals than individual investors can, and can pass the savings on to fund shareholders, Criscuolo says, advocating actively managed funds for small investors.

[See: The 9 Best Investors of All Time.]

Since a fund will hold many different bonds, it minimizes the damage from any defaults or credit downgrades that do occur.

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