For years, tax-free municipal bonds were a favorite among investors. Relatively safe, they paid interest close to what taxable government bonds offered, and then exempted holders from federal tax. Holders in California also avoided state taxes if the bonds were issued here.
But now, after the Tax Reform Act of 1986, munis have lost some of their popularity. Tax reform lowered tax brackets of many investors, so they're not as quick to buy a tax-free bond as they used to be, particularly when the after-tax yield of a taxable bond such as a Treasury bill might be higher (see accompanying chart).
Worse yet, muni yields have not gone up to compete with yields of taxable bonds. "Muni bond yields have not risen to compensate for lower tax rates," says Steven Hueglin, director of research at the municipal bond house of Gabriele, Hueglin & Cashman in New York.
Before you buy, compare the after-tax yields of taxable bonds with munis of similar quality. Should you find a muni with a better yield, there are several things to keep in mind.
Most investment advisers recommend that you have at least $50,000 and preferably $100,000 to invest directly in individual muni bonds. The bonds usually come in $5,000 and $10,000 increments and you need enough money to diversify among several issues and maturities to protect yourself against defaults in any one issue or upturns in interest rates that would force down the prices of bonds, particularly longer-term ones.
To reduce chances of holding bonds that might default, advisers generally recommend only buying bonds rated AA- or better. "I wouldn't buy anything lower than that," says Jay Goldinger, a broker with Capital Insight, a Beverly Hills brokerage.
When buying a bond, ask about the commission. With new issues, commissions are included in the price and you could end up paying as much as 5% of the bond's face value--$500 in the case of a $10,000 bond.
If you don't have $50,000 to invest, consider a bond mutual fund, which allows you to invest in a pool of munis. But be careful here too. Sometimes hidden fees and commissions can take a big bite out of your investment--at least 7.5% in some funds.