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Financial News & Tips Alan MooreL’Observateur / July 1, 1998Finding the value in municipal bonds
According to data released from the Federal Reserve, individual investors own about 74 percent of the estimated $1.3 trillion municipal bondsoutstanding. This should come as no surprise to those of you whounderstand the advantage of tax-exempt income versus taxable income.
But for those of you who don’t, the following is a quick look at tax-exempt investing.
Most municipal bonds pay income that is exempt from federal income taxes, and, in some cases, state and local income taxes in the state of issue. There are several aspects of investing in municipal bonds thatexperienced investors, as well as novices, can utilize to maximize their tax-exempt income and moderate credit and market risk.
(1) Buying municipal bonds currently trading at a premium (above par) can provide you with above market tax-exempt cash flow which often more than compensates for the premium paid. In today’s market there is usually10 basis points additional yield on premium bonds because most investors resist them. For astute investors, this is a way to earn more yield whilealso providing your portfolio with a defensive cushion should interest rates rise. Of particular interest in the premium bond area are pre-refunded bonds – short-term tax-exempt municipal bonds which are backed by U.S. Government securities. Pre-refunded bonds, because theytrade at a premium, typically yield about 10 basis points more than AAA rated general obligation bonds.
(2) Insured municipal bonds can provide a 10 to 15 basis point yield advantage over AAA rated general obligation bonds. General obligationbonds are typically issued by a municipality which might be rated B or A.
However, based on the insurance company’s claims paying ability and guarantee to pay principal and interest, these bonds are now rated AAA.
(3) The overall structure of your portfolio is as important as the individual investments. Interest rate swings can be very unsettling formost investors. Using a “laddered” portfolio structure – a portfolio withsecurities maturing every year -can help minimize this by providing you with liquidity, price protection and the ability to reinvest at higher yields should interest rates rise. Conversely, in a falling interest rateenvironment, only a portion of your portfolio is subject to reinvestment at any one time. Based on the yield curve currently, the longest maturityshould not be more than about 15 years. There is very little (if any)additional yield for the additional risk of longer maturities. Shouldinterest rates decline, this portion of your portfolio should appreciate and can offer above average market income. So, assuming typical interest ratefluctuations, which a laddered portfolio should shadow over time, a portion of your portfolio will be positioned to take advantage of interest rate swings. This common sense concept eliminates the challenge ofpredicting interest rates.
Investing in tax-exempt municipal bonds can be financially rewarding for individual investors who can also take great pride in the fact that their investment in municipal bonds is an investment in their communities as well. For this reason, it is often an opportunity that should be seriouslyconsidered.
(Alan S. Moore is a financial advisor in the New Orleans office of LeggMason Wood Walker, Inc., a diversified securities brokerage and financialservices firm that is a member of the New York Stock Exchange, Inc. andSIPC.)Back to Top
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