Municipal bonds can build communities, mitigate taxes

While the process is unavoidable, investors frequently look for effective ways to lessen the impact of taxes on the overall returns of their portfolios. More investors – particularly those in higher tax brackets – are finding that municipal bonds can help reduce their tax burden, while adding stability and diversification to their portfolios.

Issued by state and local governments, municipal bonds are commonly used to raise money for community projects and improvements. These include new highways, improved sewer systems and new schools. As with other bonds, by purchasing municipal bonds, you’re really making a loan to the issuing municipality. The state or local government, in turn, promises to pay you a given rate of interest while you hold the bond and return your principal at maturity.

One of the most attractive features of municipal bonds is their freedom from certain taxes. The bonds typically pay interest every six months and, unlike other investments, the interest you earn is not subject to federal taxes. In addition, this tax exemption can extend to state and local taxes if you live in the state or community where the bonds were issued. Keep in mind that certain types of municipal bonds may be subject to state or local taxes, or the alternative minimum tax, so it’s important to know exactly how specific issues will be treated before making a purchase.

Whether a municipal bond is subject to state or local taxes, its freedom from federal taxes on the interest it earns can significantly increase the after-tax return of your portfolio. Investing in municipal bonds can allow you to possibly diminish your overall tax burden by decreasing the amount of your income subject to taxes. Less money spent on taxes means more money for other pursuits, which may include reinvesting or saving.

While the tax advantages of municipal bonds may be appealing, several other qualities can make them an important addition to an investor’s portfolio.

For one thing, you can enjoy interest payments every six months. In addition, though it does not eliminate the credit risk of bonds, many are backed by insurance, thereby increasing the security of your investment.

The credit enhancement does not remove market risk of the bonds, and there is no assurance as to the insurer’s ability to meet its commitments. Keep in mind that bonds may be worth more or less than their original cost upon redemption or upon sale prior to redemption.

Bonds can be bought and sold in the open market, so you have the opportunity to liquidate a bond before it matures. Investors should keep in mind that as interest rates rise, existing bond prices of already outstanding fixed-income securities tend to fall. Long-term bonds are generally more exposed to interest rate risk than short-term bonds. Depending on current interest rates, the price you receive may be more or less than your original investment, but remember, you do have the option to sell if needed.

Almost every state and thousands of municipalities issue bonds each year, so you have a variety to consider. With maturities ranging anywhere from one to 30 years, you can plan for current or future income. The variety of available bonds lets you easily diversify your municipal bond holdings.

Timothy M. Reese is senior vice president-investments with A.G. Edwards & Sons Inc. Member SIPC. He can be reached at timothy.reese@agedwards.com.