Investing in munis: A smart move?

Key Points

The billion-dollar municipal bond default in Orange County, CA, was big news back in 1994. But what didn't make headlines was the fact that the investors never actually lost any of their principal, since Orange County eventually made good on its commitment to bondholders. Today, with a bond market valued at $2.34 trillion, the municipal bond default rate is less than 1 percent. Only about $1 billion worth of munis defaulted in 2006, down from $3 billion in 2005, according to Jack Colombo, editor of the Forbes/Lehmann Income Securities Investor newsletter. While they're not guaranteed fail-safe, if you follow some basic guidelines, municipals can produce a steady flow of tax-free income.

Why you need municipal bonds

Traditionally, bonds have moved out-of-step with stocks, but in recent years, they've sometimes moved in sync. In fact, Marilyn Cohen, president of Envision Capital Management in Los Angeles and author of The Bond Bible, says that "over the last year, stocks, bonds, and even commodities have all been moving in the same positive direction. But bonds are still invaluable because they lessen the overall volatility of your portfolio." And their returns can be as good as-or better than-stocks, but with less risk. The Lehman Brothers Municipal Bond Index returned an average of 5.2 percent annually over the 10 years through July. That's the tax-free equivalent of a 7.8 percent taxable return for someone in the 35 percent bracket. Compare that to the 6 percent total return you would've gotten from the S&P 500 over the same period.

If you're in one of the highest tax brackets, you could benefit most from munis' tax-free status. You won't pay federal income taxes on their interest, and in most states, local bonds are exempted from state and city taxation. And, if you live in Alaska, the District of Columbia, Florida, Indiana, Nevada, South Dakota, Texas, Utah, Washington, or Wyoming, you can buy munis from other states tax-free. Use the calculator at the Securities Industry and Financial Markets Association's website at http://www.investinginbonds.com to determine the taxable equivalent of municipal bond yields in your tax bracket and state. (Yield takes into account both the interest rate and the bond's purchase price.)

Bob Baldassari, a CPA in Fairfax, VA, makes sure his clients keep their munis outside their retirement accounts. "There's no need to shelter them since they're already tax-free," he says. "If you keep them in a tax-deferred account, the accrued tax-free interest will eventually become taxable when you take the money out at retirement." Remember that even though the income is tax-exempt, you still have to report it on your tax return.