CAA member Susan Feitelberg is a Senior Vice President and Financial Advisor with Morgan Stanley Smith Barney. She spent 11 years with Chase Investment Services as a Financial Advisor, where her specialty was working with a select number of Chase employees and their families. She is the author of The Net Worth Workout and has been quoted in articles for Money Magazine, The New York Times and UPI. She has appeared on television and radio programs including NBC’s Dateline, Fox, PBS and NY1. In 2008 she was chosen to participate in the Barron’s Winners Circle Top Women Advisors Summit and was recognized as Who’s Who in Finance. She is a member of the Family Firm Institute and Holy Cross New York Leadership Council. Susan received her BA in Economics from The College of the Holy Cross and Masters in Business Administration from Northeastern University. Susan also devotes time to cycling, running and swimming. Over the years she has competed in numerous triathlons and marathons, and has completed the Ironman in Lake Placid, NY.  This is the second of a series of columns she is writing for the CAA Web site.

With April 15^th over, many of us have written checks to Uncle Sam that we wish we hadn’t had to. And with some uncertainty about equity markets and its impact on your portfolio, one quiver you may consider adding to your portfolio are municipal bonds. Individuals are the single largest group of owners in today’s municipal bond marketplace.¹ Why? Because municipal bonds are unique securities, generally offering investors features such as tax-exempt, predictable income and high credit quality on many issues.

Municipal bonds are tax-exempt², fixed income securities that represent the debt obligations of municipal entities (states, cities, counties etc) seeking to raise money to fund projects for the public good, such as building schools, highways and hospitals. The issuer promises to repay principal in full at the bond’s maturity, and to pay semi-annual interest income – which is generally exempt from federal income tax, and in most cases, state and local taxes as well.

Is Your Federal Income Tax Bracket 25% or Higher?
One of the most compelling reasons to own municipal bonds is that interest income is generally exempt from regular federal income tax. Under most state laws, ‘home-state’ municipal bonds’ interest income is also exempt from state and local taxes. As a result, municipal bonds may generate higher net (after-tax) yields than taxable bonds of similar quality and maturity.

Your federal tax bracket plays an important role in determining whether a taxable or tax-exempt security is the better choice for you.  As a general guideline, the higher your tax bracket, the more likely you are to potentially benefit from owning municipal bonds. As illustrated below, an investor in the 33% federal income tax bracket would have to earn a 6.72% yield from a comparable fully taxable bond to match a 4.50% yield from a tax-exempt municipal bond.

Tax-Exempt Yields vs Taxable Equivalent Yields 

For illustrative purposes only, and does not represent any specific investment

Nonetheless, when choosing any fixed-income security, you need to do more than just compare yields to find the bond that is most appropriate for you; an assessment of risk and return is also important.

Consider the Impact of Interest Rates
All fixed income securities are susceptible to interest rates fluctuations; generally, if interest rates fall, bond prices rise and inversely, if interest rates rise, bond prices fall. Because bonds are typically issued with prevailing market yields, rising market interest rates causes new issues to have higher yields than existing bonds, forcing down prices on existing bonds.  Generally, longer term bonds are more sensitive to interest rate changes, and the more likely their value is to fluctuate.  However, longer-term bonds generally have higher yields, thus compensating for the time principal is exposed to interest rate fluctuations.  Conversely, bonds with short-term maturities (up to a year) normally experience relatively minimal changes in price as interest rates fluctuate, but also typically provide lower yields.  Another point to consider: If you hold your bonds to maturity, your principal will be returned in full, yet, if you sell your bonds prior to maturity, the price you receive may be more or less than your original purchase price.

Credit Risk
You should consider every bond’s creditworthiness; if an issuer is unable to meet its financial obligations it may fail to make interest and principal repayments.  Although municipal bonds are generally considered to be high quality investments, not every issuer has the same tax base or sources of revenue.

Consider Call Provisions
Many municipal bonds have call provisions; the issuer has the option to redeem the bonds prior to maturity. If a bond is called, you bear the risk of reinvesting the proceeds at a possibly lower rate of return, depending on market conditions, potentially impacting your ability to plan your future income stream 

Are Municipal Bonds for you?
As well as generating tax-exempt income, the municipal market is attractive in terms of investment quality, maturity, sector focus, and geographical diversity.  Municipal bonds could be an important diversification and tax planning tool within your fixed income portfolio. 

¹ Source: Federal Reserve Board Flow of Funds Account, September 2008

2 Municipal bonds are generally exempt from federal income tax. Typically, state or local tax-exemption applies if securities are issued within one’s state or city of residence. If you are subject to the Alternative Minimum Tax (AMT), interest on ‘private activity’ municipal bonds is considered a preference item.