Pictures told the story at the annual meeting of the Narragansett Insured Tax Free Income Fund held in Providence recently. Color shots of buildings such as Andrews Hall at Brown University and the Providence County Courthouse showed investors how their mutual fund was building the state. Because the fund invests in municipal bonds issued in Rhode Island only, people who buy shares in it have a chance to develop their communities along with their portfolio.
And by buying municipal bonds they are able to do something else: Escape taxes. Since municipal bonds generally are not taxable at the federal or state level, they can be attractive investments to people in high tax brackets, experts say.
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Government bodies issue municipal bonds to build hospitals, schools, and other capital projects. They can be general obligation bonds, backed by the municipality’s ability to tax, or revenue bonds, backed by the income the project will generate through charges applied to the users. Public housing is an example of a project often built through revenue bonds, according to FMS Inc., a Miami company which sells municipal bonds.
Investors in tax brackets of 28 percent or more are using municipal bonds to reduce volatility and add diversity to their portfolios, while shielding their money from taxes, experts say.
“What we tend to see is that investors that are in high tax brackets are finding very few tax breaks, so to speak,” said Tracy Davignon, branch manager of the Fidelity Investment’s Investors Center, which opened at Providence Place last week.
“For someone in a high tax bracket, municipal bonds provide them with a better return than the typical taxable bond alternative,” she said.
Indeed, the lack of a tax often makes up for the fact that municipal bonds usually offer lower interest rates than corporate bonds or certificates of deposit. Therefore, investors must consider the after-tax yield of taxable investments to compare them accurately with tax-free bonds.
To illustrate the difference, FMS compares the returns of two investors in the 36 percent tax bracket. The first puts $30,000 into a tax-exempt bond earning 5 percent, the second puts $30,000 into a taxable investment earning 7.5 percent. The first would earn $1,500 per year in interest, while the second would earn $2,250. Since the second investor’s investment is taxed, however, he loses $810 of the interest he earns, reducing his net return to $1,440 — $60 less than the investor who bought the tax-free bond.
Therefore, the yield on the taxable investment is actually only 4.8 percent, according to the FMS example.
Investors considering municipal bonds may buy individual issues or invest in a bond mutual fund. Which path to take depends on your individual circumstances, experts say. For example, those who are looking for monthly income typically choose a mutual fund because they pay interest monthly, whereas individual bonds pay interest semiannually.
Another difference is that investors usually have more flexibility in adding to their investment in a mutual fund. For example, once you make the minimum initial $1,000 investment in the Narragansett Tax Free fund, you may invest any amount in the fund thereafter. With Fidelity municipal bond funds, you must invest $2,500 initially, Davignon said. After that, you may add to your investment in increments of $250 or more. Those who buy individual bonds generally have to buy in $5,000 increments, she said.
Current market conditions are also a factor, said Jon Coltune, manager of the North Miami Beach office of FMS Inc. When interest rates are rising rapidly, he said, funds are usually worth less than new issues because the funds are tied up in lower rate bonds. When interest rates are dropping, however, new issues yield less than bond mutual funds. But Coltune added that the difference in yields is often rather slight.
“Typically, the yields you find are not dramatically different,” he said.
The creditworthiness of the bond issuer is also a consideration. Three companies rate the creditworthiness of bond issuers: Moody’s Investors Service, Standard & Poor’s Corp. and Fitch Investors Service. Ratings range from ‘triple A,’ the best, to, depending on the company, C, D, DD, or DDD, the worst. Some mutual funds, such as Narragansett Insured Tax Free Income Fund, invest in bonds that have been insured only. Because they have been insured – meaning that investors will receive the interest and principal due to them, even if the issuer defaults – the rating of every bond in the fund rises to ‘triple A,’ according to Citizens Bank of Rhode Island, the fund’s investment sub-advisor.
Interest rates and the general health of the economy affect the performance of tax-free bonds, experts say. Municipal bonds have been rising in popularity lately because interest rates are still fairly good and because cities and towns are in good shape, said Michael Dor-fsman, of the Bond Market Association, which represents banks and firms that underwrite, trade, and sell debt securities.
Currently, the rate of return investors can receive on tax-free bonds is comparable to what they could get with a Treasury bond – which is subject to federal taxes, he added.
“Demand right now is fairly strong – interest rates are fair (and) you’re able to buy a municipal bond for almost the same amount of interest return,” Dorfsman said. “Cities and towns are in strong shape, so they have the money to (build).”
According to the association, $1.5 trillion is now invested in municipal bonds, compared to $1.18 trillion in 1990.
