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Personal Finance > Investing
Munis a 'screaming buy'?
November 30, 1998: 10:04 a.m. ET

Municipal bonds are keeping pace with -- and even beating -- other bonds
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NEW YORK (CNNfn) - Municipal bonds may be an afterthought to some investors, but they're currently offering a payout which can top some of their better-known bond counterparts.
     Yields for municipal bonds, or "munis," have been falling during the past six months but they have not been falling as fast as those of the benchmark 30-year Treasury bonds. For the first time since 1986, the yields on both types of securities are comparable.
     However, when coupled with the tax breaks you get, municipal bonds are quickly becoming even more enticing than their bond counterparts, according to Skip Morton, director of fixed income marketing at Tucker-Anthony.
     "They're becoming a screaming buy," said Morton.
    
Munificent municipals

     Municipal bonds are debt obligations issued by states, cities and countries used to pay for constructing projects for the public good.
     For example, if a state decides it needs to expand a highway to assist businesses in the area, it may issue millions of dollars in bonds to raise money for the project.
     When individuals or institutional investors buy these bonds, they're essentially lending the money to the issuer. In turn, the issuer agrees it will pay you interest, along with paying you back the original amount (principal) at the maturity date.
     Morton quote
     Government bodies have been particularly keen on issuing municipal bonds this year. The largest-ever municipal bond issue -- $3.4 billion -- occurred in May, with over $300 billion in tax-exempt issues estimated this year, according to a report by Jame Cooner, senior vice president at the Bank of New York.
     Additionally, in the November elections, voters in the United States approved a record $25 billion in new bond sales around the country.
     Cooner said the quality of those municipal bonds is strong.
     "The bonds aren't being put out by states and municipalities that are financially weak and in desperate need of money. Like the federal government, most find themselves with strong tax revenues and declining burdens for social services," he explained.
     Municipal bonds can be a safe investment as well, according to Morton of Tucker-Anthony.
     "A lot of people don't realize that the rate of default in the municipal bond market is very low (about 1 percent)," he said. "They're very attractive for the conservative investor."
     Many municipal bonds are backed by insurance. If there were a default, the insurance company will take over the issuer's financial obligations to you.
     Credit rating companies, such as Moody's, Standard & Poor's and Fitch, take this insurance into account when coming up with their ratings of these municipal bonds.
     In addition, they look at other factors, including the issuer's underlying financial position and its official statements.
     While these companies rate the same bonds, the terms they use vary. Investors can use this chart to discern between the various ratings methods.
    
Rates and yields

     Munis have benefited from a fall in interest rates lately. The actual interest rate of a bond, known as the coupon rate, is set when you purchase the muni and can't be changed during the term of the bond.
     However, while most municipal bond owners hold their bonds until the maturity date, others for whatever reason may choose to sell them.
     This is where the current interest rate picture comes in. When you choose to sell your bond before maturity you'll be at the mercy of current market prices.
     In a time of declining interest rates -- as is currently taking place -- the price of your municipal bond may increase.
     This is because when interest rates drop, new municipal bonds have lower yields so your older security will be worth more.
     muni benefits
     The reverse is true as well. Rising interest rates give new municipal bonds better yields and make older ones less attractive.
     But the lower interest rate climate isn't the true advantage of municipal bonds currently, according to George Friedlander, fixed income research strategist at Salomon Smith Barney.
     "This is a unique opportunity for investors to achieve nearly the same high yields as Treasurys in a tax-free investment," he said.
     Municipal bonds can provide a one-two and even three punch since the interest income you receive from investing in munis is free from federal taxes.
     In most states, municipal bond interest is also exempt from state and local taxes as long as the muni was issued within the state.
     That means all things being equal -- if a muni and a 30-year Treasury have the same yield -- the tax advantage of the muni will put you ahead of the game.
     For example, if you are in the 36 percent federal tax bracket and have $30,000 to invest you can consider a tax exempt bond yielding 6 percent and a taxable corporate bond yielding 8 percent.
     The corporate bond sounds like the better deal, right?
     However, with the municipal bond you'd earn $1,800 in interest and pay no federal taxes. The corporate bond would give you just $1,536 after you deduct the federal taxes you'd have to pay on that interest.
     You only get the tax exemptions if you hold your municipal bond to maturity, however. If you sell it before then at a profit, the government considers that a capital gain and you'll have to pay taxes on the profit.
     In addition, the benefits of a municipal bond can be pulled out from under you by the issuer. Morton warned potential investors to read the bond's financial information before they purchase them.
     Many bonds have what's known as a "call" feature written into them. This allows the issuer to call, or buy back, the bond at any time it wants, regardless of whether you want to sell it.
     For instance, if the city of New York issued you a 30-year muni 10 years ago with a yield of 9 percent, it could call it back today and you would not be able to do anything about it.
     Issuers may do this because the current interest rate climate would allow them to issue that debt at a lower rate, which would cost them less money in the long run. Essentially, they would be refinancing their "loan" in the same way you'd refinance your mortgage if interest rates fell.
     Despite these risks, it would be wise not to overlook municipal bonds. Salomon Smith Barney's Friedlander said the current market climate makes it smart to "lock in" munis at these higher yield rates.
     In addition, as investors near the end of 1998 they should consider the upcoming tax season. Often, said Friedlander, investors can hold onto more of their income by keeping their assets in munis and out of Uncle Sam's clutches.Back to top
     -- by staff writer Randall J. Schultz

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.