Wednesday, November 24, 2010

Municipal Bonds & The Income Investor

The long held practice of using municipal bonds to create tax advantaged income is coming under scrutiny.

As we have previously discussed, municipal bonds have been excellent investments for money held in taxable accounts. They are not appropriate for tax deferred accounts like 401K's, IRA's, or other retirement accounts. However, many people have money in taxable accounts and to maximize their net income and reduce their taxes on income, they use municipal bonds.

In my career, I have been through at least one very well known municipal bond crisis and that was the bankruptcy of Orange County, California in 1993. In spite of this crisis, interest and principal on these bonds was paid. This is a confidence builder. But, does that confidence exist today? Will holders of bonds from Harrisburg, PA fare as well?

Lending your money to a municipality is a dicier venture today than even in 1993. We are in an illiquid and inefficient market. A few states such as Indiana have made progress toward balancing their budget and therefore a state like Indiana can provide tax advantaged income that is relatively safe. The BAB, build America bonds, which are taxable and not guaranteed by the U.S. Government complicate the issue even more.

Overall, the supply and demand of municipal securities is out of balance and this means you must settle for a little less income in exchange for safety. When possible, purchase bonds that are insured and those backed by the taxing authority of the state rather than the source of income coming from bridge tolls or hospital revenues or sports arenas.

I like simple investments and municipal bonds are not simple. However, using the SIFMA site investinginbonds.com, you can learn a lot about the bonds by simply entering the CUSIP number. In addition, your brokerage will be able to provide you with even more information.

I remind you to never buy bonds funds when the risk of rising interest exists and it exists today.

So tread carefully and know everything you can about the State, County, or City to whom you are lending your hard earned money.

Happy Thanksgiving & Very Truly Yours,

TheMoneyMadam

Next week another dividend machine idea!