Are Municipal Bonds Coming Back in Vogue?

Late last year, financial analyst Meredith Whitney rattled investors when she warned that many municipalities were poised to default on their bonds, and municipal bonds sold off.

Today, however, they’re making a comeback as volatility in other financial markets has rekindled interest in an asset class that has long been considered a solid investment.

Municipal bonds are issued by state and local governments, counties, cities, schools and water districts, and agencies.

They’re used to finance public projects such as roads, schools and airports and certain types of private projects, such as nursing homes and assisted-living centers.

Traditionally, investors have purchased municipal bonds primarily because they offer stability of principal and tax-free income.
Defaults in the market are rare, and the interest on municipal bonds is exempt from federal taxes. And because most states don’t require their residents to pay state and local taxes on interest received from bonds issued by political entities within the state, the interest may also be exempt from state and local taxes.

For example, in most cases a resident of Massachusetts wouldn’t have to pay federal taxes or state or local taxes on interest and dividends paid by a state of Massachusetts bond or a mutual fund that holds bonds issued by political entities within Massachusetts.

Because municipal bonds offer tax-free income, they are typically sought by investors with higher income levels. Why? Although the actual yield may be lower than on a taxable investment, the “tax-equivalent yield” – the yield after you’ve taken account of the fact that you aren’t taxed on the bond’s interest – may actually be higher.

Thus, the addition of municipal bonds to your portfolio may not only lower your tax bill – it may also help protect your portfolio from volatility. Your financial advisor can help you decide if municipal bonds are right for you.