Keep the IRS Off Your Income: 3 Plays on Municipal Bonds

Don't miss out on the tax advantages of munibonds

Keep the IRS Off Your Income: 3 Plays on Municipal Bonds

Investors in municipal bonds took it on the chin last year after the Fed’s “tapering” policy sparked fears of rising interest rates, while Detroit’s bankruptcy filing redefined the term “default risk.” Still, a solid case remains for municipal bonds — especially if you’re a fixed-income investor who wants to protect your nest egg from the tax man.

bond vintage Keep the IRS Off Your Income: 3 Plays on Municipal BondsMunibond investors typically pay no federal taxes on their interest income — and similar state and local tax breaks are often available if you buy bonds issued in the same state where you live. So municipal bonds’ tax-free status is a boon for higher-bracket taxpayers who will see an additional 3.8% Medicare tax on their investments this year — on top of a rate increase from 35% to 39.6% for the top tax bracket.

Municipal bonds come in two flavors — revenue bonds and general obligation (GO) bonds. Revenue bonds fund improvements in projects like airports or power plants that generate income. These bonds can repay investors only from that income. In a GO bond, municipalities can raise taxes to repay bondholders.

There’s more good news: Detroit and the California cities notwithstanding, bankruptcy filings or defaults are rare occurrences in the munibond sector. And while interest rates are a headwind, the Fed is likely to go slow in its efforts to scale back its own bond buying in the months to come — and that policy has largely been priced in.

That said, here are three plays on municipal bonds that can ease the tax headache for top-bracket investors:

Municipal Bonds: Individual Bond

Hallsville Independent School District (Harrison County, TX) Unlimited Tax School Building Bonds Series 2010A. (CUSIP: 406360MP9)
Rate:
4%

Buying an individual bond as opposed to shares in an ETF or mutual fund is a slightly different proposition. Individual bonds usually are traded by brokers or dealers on the OTC market and investors can purchase them online, usually for a flat fee. Investors may buy a municipal bond on the primary market when it is first issued or on the secondary market — the minimum entry point is usually about $5,000.

Individual bonds make sense for an investor who wants to exercise complete control over the investment and/or wants to avoid potential interest rate risk by holding the bond until maturity. That’s where the added safety of an individual bond’s credit rating comes in to play.

I currently like the Hallsville Independent School District (Harrison County, TX) Unlimited Tax School Building Bonds Series 2010A. (CUSIP:406360MP9). Moody’s upgraded Hallsville ISD’s credit rating last October to A1 from A3 — a move that favorably impacts the school district’s nearly $85 million debt. The school district, Moody’s observed, has boosted its financial reserves and has a new management team in place.

Additionally, the district settled outstanding taxpayer litigation and is growing its student enrollments.

The bonds represented above were part of a total issue of nearly $2.65 million in April 2010; they have a maturity date of Feb. 15, 2015, and have an interest rate of 4%.

Municipal Bonds: ETF

iShares185 Keep the IRS Off Your Income: 3 Plays on Municipal BondsiShares National AMT-Free Muni Bond ETF (MUB)
Yield: 3%

For fixed-income investors looking to gain exposure to the municipal bond market but for whom safety, diversification and liquidity are top concerns, the iShares National AMT-Free Muni Bond ETF (MUB) is a solid choice.

Exchange-traded funds are appealing because they offer greater diversification and liquidity than an individual munibond. They also typically have lower fees than mutual funds. Another advantage: ETFs trade over a major exchange like stocks, rather than settling at the end of the day like mutual funds.

MUB is the 800-pound gorilla in municipal bonds, not just in terms of assets under management ($3.1 billion) but it also gives investors exposure to general obligation and revenue bonds from a wide range of state, county and municipal issuers. It also holds bonds of different maturities for further diversification.

This bond fund is a good choice for any income investor with a basic brokerage account — it gets you into municipal bonds and their tax benefits, plus MUB avoids any municipal bonds that might be subject to the alternative minimum tax, in a single vehicle. Conservative investors — particularly those in retirement –will enjoy the extra margin of safety and stability MUB delivers 95% of MUB’s munibond holdings rated “A” or above.

MUB is a popular bond fund, managing net assets of $3.1 billion. It’s also cheap, at an expense ratio of merely 0.25%, or $25 annually for every $25,000 invested.

Municipal Bonds: Mutual Fund

Oppenheimer185 Keep the IRS Off Your Income: 3 Plays on Municipal BondsOppenheimer Rochester Intermediate Term Municipal Fund (ORRWX)
Yield:
3%

If you’ve got the stomach for a little more risk and don’t mind the crowds running toward the exits, Oppenheimer Rochester Intermediate Term Municipal Fund (ORRWX) offers a lot of exposure to Puerto Rico might be a place to hide some mad money. Three of ORRWX’s top 10 holdings are in Puerto Rican bonds.

Puerto Rico’s debt in particular tumbled last year as the economy continued to slog through an intractable recession. It didn’t help that bond rating agencies Moody’s and S&P lowered Puerto Rico’s debt rating to junk levels. Nonetheless, despite current turmoil in the territory, Oppenheimer Rochester is not jumping ship — the firm is encouraged by high yields and Puerto Rico’s willingness to prioritize the bonds over other obligations.

And more promising, against that backdrop of chaos, Puerto Rican debt is starting to get up off the mat.

This bond fund offers a 3% yield, and despite its Puerto Rican holdings, the fund isn’t completely wild — 77% of its holdings are rated “A” and above. Also, bondholders are exempt from federal, state or local taxes regardless of where they live in the U.S.

Even so, fixed-income investors at or nearing retirement should tread carefully with this fund because Puerto Rico is not likely to emerge from its challenges anytime soon.

ORRWX, which is actively managed by Oppenheimer’s Senior Portfolio Managers Michael Camarella and Charlie Pulire, charges 1% in expenses and a front-end sales load of 2.25% for A shares. Minimum initial investment is $1,000.

As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities. 


Article printed from InvestorPlace Media, http://investorplace.com/2014/03/municipal-bonds-bond-fund-mub/.

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