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What You Need to Know About Municipal Bonds

Municipal bonds can add some pizazz to the yield of your fixed-income ladder, but, as usual, do-it-yourself investors should proceed with plenty of hesitation.

Municipal bonds are issued by local governments to help pay for a wide assortment of public projects such as building bridges, hospitals, schools and the like. For in-depth background on "munis," visit the Security Industries and Financial Markets Association's (SIFMA) Web site Investinginbonds.com.

The interest earned on most munis is exempt from federal income tax and sometimes from state and local taxes as well. That's what attracts a lot of investors. But munis are complicated and you should spend plenty of time exploring the territory before buying. For example, if you sell the bond and have a capital gain, the gain may be subject to federal tax.

Individual bonds have become a lot more accessible to people who manage their own portfolios. Plenty of Web sites, including SIFMA's, let you peruse bond listings. And when it comes to buying, some institutions, such as Fidelity and Vanguard, have $5,000 purchase minimums, which make the bonds affordable to a much wider group of investors.

Bonds and notes issued by the U.S. Treasury are considered a fail-safe investment because they're backed by the U.S. Government. But the picture is a bit less clear when it comes to bonds issued by municipalities. You can have credit risk with munis—the issuing municipality may not be able to pay the interest or the principal. But the reality is that historically, munis have been extremely safe investments.

Give yourself a little added safety net by buying munis that are insured by a private insurance company—it automatically gives the bond a AAA rating. Is it 100 percent foolproof? Maybe not, but how many investments can claim that status? Also, some advisers say you should stick with general obligation bonds versus revenue bonds because governments can use their taxing power to back general obligation bonds.

You may also want to consider limiting your municipal bond purchases to ones that state they're not subject to the Alternative Minimum Tax.

Jason Flurry, Certified Financial Planner and president of Legacy Partners Financial Group in Woodstock, Ga., suggests using insured municipal bonds in a ladder that could be comprised of a variety of bonds such as munis, Treasuries, government agencies and CDs.

"One could anchor the long end of a ladder with these and smooth out the thrills and spills of the short-term yield curve. We're looking at government agency notes in the 10- to 17-year range as a complement to the long (securities) and filling the gaps with some AA, or higher-rated corporate notes. All things considered, we can lock in a net yield of around 6.25 percent to 6.5 percent this way."

This may be a much longer ladder than many people are used to, especially if you only ladder CDs. Flurry says these long ladders are best for retirees who have enough money to live on but need to lock in an income stream that they won't outlive; one that will keep them ahead of taxes and inflation, and will supplement their Social Security or pension.

"We'll have an ultrashort-term area which is maybe a year or less, a short term of one to three years, and then an intermediate term which is three to maybe seven years," says Flurry.

"The sweet spot for the government agencies appears to be between five to 15 or 17 years. The munis aren't quite as attractive there. They start to get attractive at 17 to 20 years out," he adds.

It's one thing to select various bond maturities for a ladder; it's another to select the right bonds. Some advisers say the vast majority of do-it-yourselfers should stick with mutual funds and exchange-traded funds (ETFs) when it comes to stocks and bonds.

"There's an adage with respect to investing that nobody should own anything they can get killed at," says Leonard Wright, certified public accountant and CFP, in San Diego.

"People like to own something individually to see it on the statement, but I think for the typical investor that's where muni bond mutual funds or ETFs come into play. You get widespread diversification and you have an ability to spread your risk among multiple municipal entities. If an individual bond goes bad you could lose 15 percent of your portfolio, or if it stops paying interest it could be a high percentage of your income stream."

There are hundreds of mutual funds that specialize in municipal bonds. You'll find ones focusing on short-term, intermediate, or long-term bonds, high income, AMT-free, and, of course, a variety of state-specific funds. There are fewer exchange-traded funds available but that number will undoubtedly grow as investors turn to ETFs to get muni exposure, says Matthew Tucker, head of fixed-income strategy at Barclays Global Investors, which created iShares ETFs. IShares offers four municipal bond ETFs.

"If you buy a bond ladder you're typically buying a series of individual bonds and then as the bonds mature you're reinvesting by buying the longer maturity bond. Essentially you're perpetuating that ladder," Tucker says.

"The nice thing about the ETF structure is because it's a managed fund you're getting that management for you. For S&P National Municipal Bond Fund (MUB), Barclays will invest in a broad selection of muni bonds across the curve. As bonds mature we do the rebalancing for the investor. So, they can buy one product, the ETF, and get that rebalancing built in."

Whether you delve into munis through individual bonds or mutual funds or ETFs will depend in large part on your investment philosophy, risk tolerance, and long-term goals. The availability of individual bonds for $1,000 each on sites such as Fidelity, and the rise in bond ETFs enable most investors to participate in these areas of the market. It's relatively cheap diversification.

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