Municipal Bond Scare Stories Mask Strong Returns

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Should you buy, sell, or hold muni bonds? If you are in a higher tax bracket, muni bonds are an attractive investment because of their tax-free income and relative safety. Even if your means are more modest, munis can be an effective way to diversify your portfolio, especially if it's heavy on stocks.

As with other investments but even more so, diversification is the key. You certainly shouldn't put all fixed-income eggs in a muni bond basket. Rather, it's a place for a portion of your total fixed-income holdings, which might also include corporate and U.S. bonds.

It's important to consider whether you have the time and skills to research and judge which bonds to buy. Most individual investors would not pass this test, so hiring a manager makes good sense. You can get this expertise by investing in mutual funds (closed-end or open), exchange-traded funds (ETFs) or separately managed accounts – all run by professional investment managers. As a practical matter, few individual investors can afford to invest directly in munis because high minimums for purchasing a single bond preclude diversification for most people.

Here are some points to keep in mind about investing in munis:

• Diversify geographically. Vary your investment among different states and cities – of course, those with higher credit ratings because of lower risk. Like other bonds, munis are rated by Standard & Poor's and Moody's from top-rated AAA to CCC, for junk.

• Focus on revenue. Concentrate on bonds for projects that deliver a direct return to the government or authority issuing the bond, such as a toll road or a bridge. This decreases your risk, compared with the vague accountability that sometimes bedevils purchasers of general obligation bonds, in which governments pledge to pay bond holders rather than linking these payments clearly to revenues received from specific projects.

• Look for insured bonds. This usually means they're more expensive, but it gives comfort to the buyer. This is no panacea, however. If pervasive conditions affecting many governments trigger widespread defaults, in some states this insurance may not be worth the paper it's printed on.

• Don't be penny-wise and pound-foolish about risk versus rates. Often, you'll find that a hair more interest is accompanied by significantly more risk.

• Never hold muni bonds in a tax-deferred vehicle such as an IRA or a 401(k) plan. You want to save the limited tax-deferred capacity in IRAs or 401(k)s for investments that are taxable.

Regardless of which muni issues you decide on, remember that if returns sound too good to be true, they probably are. If you see sky-high rates, have another look at risk factors.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group. He advises individual investors and endowments, and serves as the advisor to CIFG UMA accounts. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com.

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