A wide range of investors ought to take a good look at tax-free municipal bonds. Normally, they're recommended for people in above-average income brackets. But tax-free interest rates are especially high today, compared with the taxable rates you get in Treasuries and other securities.
The highest rates are for long-term bonds: Prime 30-year tax exempts yield 9.8 percent, compared with 12.6 percent on taxable 25- to 30-year AA utilities. That gives municipals a clear advantage for married couples in the 25 percent bracket and up -- which covers a net taxable income next year, after all deductions and tax credits, of more than $25,600.
At current interest rates, single people need a net taxable income, after all deductions, of at least $15,611, which for them is the 23 percent bracket and up.
In the 50 percent bracket, today's rates on long-term bonds are the equivalent of a 19.6 percent taxable yield.
Municipal bond rates are fat today because of the huge volume of these securities which have come to market in recent months. Record-high new offerings exceeded $11 billion in October, compared with the previous high of $9.8 billion offered in August. To sell all these bonds, interest rates had to stay exceptionally high.
One reason for this flood of new issues are the various technical changes in federal law, whose effect runs out Jan. 1. So it's not at all clear how long today's comparatively high interest rates will last.
In terms of yield, it's only the medium- to long-term municipal bonds -- or bond mutual funds and unit trusts -- that make sense for middle-income investors. Tax-free money-market mutual funds are yielding only 5.69 percent, compared with 9.47 percent on a taxable money fund. To come out ahead in the tax-free fund, you would have to be at least in the 42 percent bracket (taxable income, after deductions, above $62,450 for married people and $43,190 for singles).
You can figure out when tax-exempts might pay by knowing your tax bracket and the yield of the tax-free investment you have in mind. For example, say you're in the 30 percent bracket and considering a municipal-bond mutual fund yielding 9.5 percent. You subtract your tax bracket (30) from 100 percent and divide the result (70) into the tax-exempt yield. In this case you get 13.57 -- which means that a taxable investment would have to pay more than 13.57 percent to give you a higher return than you'd get from tax exempts.
But there are three important risks to understand before you buy municipals:
(1) Risk to your principal. If you have to sell your bonds before maturity, and interest rates have risen since you bought, you will lose money. So it's best to invest with savings that you expect to put away for a long time. But maybe not for too long. More can go wrong with a 20- or 30-year bond or unit trust than with a bond or trust maturing in 10 years.
(2) Default risk. Municipal bonds rarely default. But the Washington Public Power Supply System (WPPSS) quit paying on $2.25 billion worth of bonds last year, sabotaging the savings of many investors who hadn't even realized they were taking a risk. And you can't count on the bond-rating agencies always to guide you to a gilt-edged investment.
WPPSS also proved the rule that, rather than sinking all your money into a single bond, it's safer to own a portfolio of bonds in a mutual fund or unit trust. Any losses will be far less than if you had concentrated your investment in one, bad municipal bond alone.
Some bonds and unit trusts carry insurance that will pay your interest and principal in case of default. But to get this security, you give up perhaps 0.25 percent in yield. Other bonds are backed by letters of credit from a bank. In this case, double-check to see that the bank will really pay bondholders in a default; some letters of credit give lesser guarantees.
(3) Inflation risk. With inflation low and interest rates high, this is not so great a risk as it used to be. Nevertheless, fixed-interest payments lose purchasing power every year. Generally speaking, younger people are better off investing for growth, leaving the serious interest-rate investments to people for whom income and safety matter most.