At Arm's Length - Financial Commentary about Money, Investing, and How It Affects the Average Investor

At Arm's Length: 11.14.05

Municipal Bonds: An Unheralded Winner

Not that long ago, Americans were lining up at lottery machines to buy a ticket on the chance to win $340 million. A princely sum that, even after taxes would catapult that average dreamer into the realm of the super rich.

In all corners of the investment world, discussions surfaced on what best to do with that much money should someone within earshot of the conversation be the winner. The average American would assume that money managers would probably offer safe respite for that wealth in the confines of a sophisticated hedge fund. Stocks provide growth and with that much money, almost but not quite impossible to spend in a single lifetime, it would seem the logical place to park that much cash.

Without a nod to his circus-like antics and shout-from-the-roof buy/sell recommendations on his show Mad Money, Jim Cramer actually offered the single best advice for the newly minted millionaire: municipal bonds.

You don't hear much about munis, as municipal bonds are abbreviated. They not only hold the key to wealth preservation but they have been, for all of their second class status among risk seekers, out performing Treasuries and doing so under the investment radar.

A municipal bond is issued to pay for such exciting things as roads and buildings at the state and local levels and is largely exempt from federal taxes as well as any taxes levied by the issuing community. For someone in a high tax bracket, this savings can be substantial. Because of this very organic leaning, foreign investors do not look to municipal bonds.

Left to regular Joes and Janes, the muni is the safe bet of choice. It is available in many 401(k) offerings as funds that focus on multiple and laddered holdings. Offered in IRAs and S.E.P.'s, a portion of a portfolio dedicated to this tax friendly investment will offset many riskier investments. When Roth 401(k)s are offered next year, these will be a welcomed addition to a conservative retirement plan.

So why, if these are such advantageous investments for the average investor are they so under-touted? For one, the tax-free status isn't universal. Bonds issued in a neighboring state do not carry the same tax-free status as your state of residence. This makes owning individual bonds not as attractive as owning a fund.

For residents of states who buy a bond fund with munis held from their own state of residence will find a double incentive to buy. Not only do you gain the tax advantage but gain additional safety from a managed fund and the strategies they can use to gain maximum return, the best price and the optimum tax savings.

Bond funds also prove to be the best way to own these types of bonds. Munis tend to be closely grouped together when it comes to the yields offered. A fund manager can seek a slightly better return by assuming slightly riskier bonds.

The returns on municipal bonds are funded in either one or two ways. The first and ultimately best method comes from guarantees from the state's own treasuries. Others offer payment in the form of revenues from the project itself. The best example of that would be toll roads or stadiums.

The current fear among potential buyers is the possibility of changes in tax law. Personally, I don't expect any tax law changes in the coming year, if at all. But bond investors worry and muni investors worry more than most. Changes in their tax-favored status would change how these investments attract funding and would close the gap in the yield between munis and Treasuries. Possible, but for the near term, not likely.

Another worry these investors have comes in the form of interest rate bets. Some funds operate without regard to the recent interest rate hikes; other change their cash positions to reflect changes in the interest rate environment.

Even without a huge lottery windfall and without any changes in tax laws, munis hold a certain attraction for the squeamish investor worried about return and safety. For now, the gap between Treasuries and munis remains unheralded and very attractive.

The previous week's articles.

COLUMN REQUEST | AT ARM'S LENGTH ARCHIVE | WHO WE ARE | CONTACT US | LEARNING CENTER