December 2001 Bulletin

All muni bonds not the same

Income is tax-free, but there still is credit, market risk

By Joel M. Blau

Many physicians, unhappy about the fluctuations they have experienced within their investment portfolios, are exploring other opportunities. Even with dramatic fluctuations, the overall risk associated with equity (stock) investments held in qualified retirement plans is often reduced through diversification and a longer timeframe. However, when searching for an investment to hold outside of a retirement plan, municipal bonds can provide exposure to another asset class that alternatively focuses on generating federal tax-free income.

Taxable bonds, such as corporate bonds, should be analyzed on an after-tax basis since the interest can be taxed at a rate as high as 39.6 percent (next year the maximum tax bracket will be 38.6 percent). Corporate bond income is also subject to state taxes, bringing the taxable rate to over 40 percent. On the other hand, municipal bond interest income is received tax-free at the federal level, although in some cases may be subject to the alternative minimum tax.

State and local governments, or municipalities, issue municipal bonds to finance public projects such as schools, sewer systems and roads. Municipal bonds can be categorized as "general obligation" or "revenue" bonds. General obligation bonds are backed by the full faith, credit and taxing power of the municipality. In contrast, "revenue bonds" are used to finance tunnels, bridges, hospitals, and other public works, and are backed by the expected income from these projects.

With either type of bond, you as the investor lend money to the municipality, which "promises" to pay you a predetermined amount of interest, typically on a semi-annual basis, plus return your principal to you on a specified maturity date. As an investor, you can choose to hold the bond until maturity or sell it prior to maturity through the municipal bond marketplace and receive proceeds based on the bond’s current value. This is known as "market risk." As interest rates rise, the value of an existing bond decreases, since it pays a fixed rate of interest lower than what is being offered in the market. On the other hand, bond values appreciate when interest rates decline. This inverse relationship means a bond’s market value is dependent on the number of years remaining until maturity. The longer the maturity time frame, the more sensitive the bond will be to interest rates.

If market risk is an issue for you, focus on shorter-term bonds that will pay a lower rate of interest. If current interest is not a factor and you can afford to forgo the semi-annual income, an alternative would be "zero-coupon" municipal bonds. These bonds are bought at a discount of the face amount, pay no interest, but mature at the higher stated maturity value.

Other risks include "credit risk," which rating agencies define as the ability of the issuer to pay back interest as well as principal. With higher risk, a greater amount of interest would be promised as opposed to municipalities with a high credit rating, which pay a lower amount of interest to their investors. Beyond credit and market risk, there is also the risk that the issuer will "call" the bond prior to maturity at a pre-stated value. This typically happens as interest rates fall, and the issuer can "refinance" or offer new bonds at a lower rate.

Keep in mind that municipal bonds are not for everyone since tax brackets will dictate their effectiveness. Prior to investing in municipal bonds, be sure to gain a thorough understanding of the nuances and appropriateness of this asset class by speaking with your tax and investment advisors.

Joel M. Blau is president of MEDIQUS Asset Advisors, Inc.

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