Though they have been a haven for high-income investors, municipal bonds aren't just for the wealthy. It's true that the higher your tax rate, the more you save by investing in tax-advantaged securities. However, that doesn't mean you have to be in the high-income category to enjoy the benefits of these investments.
As I discussed in my first Foolish article, I'm not an advocate of folks arbitrarily shifting assets into bonds based on the machinations of Mr. Market, particularly with interest rates at these low levels. That said, for those who plan to hold their bonds until maturity, and are merely seeking stable income, bonds could make all the sense in the world.
From the beginning
First off, bonds are debt securities that are issued by corporations and government entities to raise money for various purposes. Typically, investors purchase bonds with the understanding that they'll receive semiannual payments at a fixed rate of interest, and have their principal returned when the bond matures.
The big risk here is that the bond issuer will run into financial trouble and won't be able to pay, which is exactly what happened to investors who purchased bonds from such companies as Enron. So, though bonds are generally regarded as being safer than stocks, you still have to choose carefully.
Municipal bonds, or "munis," are bonds that are issued by local or state governments to finance all sorts of projects, from bridges and schools to airports and toll roads.
The biggest difference between munis and other bonds is that the interest from municipal bonds is usually free from federal income tax, and, if you purchase the bond from the state or city in which you live, it may be free from state and local taxes as well. That can be a fairly large difference, depending on your tax bracket.
Within the muni category, there are several different types of bonds. Here are some of the most common: general obligation, revenue, housing, tax anticipation, and revenue anticipation. The main difference between these categories is simply how the issuer is going to come up with the money to make the bondholders' interest payments and eventually repay the principal.
For example, general-obligation bonds are backed only by the full faith and credit of the issuer. With these bonds, the government entity can pretty much repay the bond with whatever funds are available. Revenue bonds, on the other hand, are funded by income that will be generated by the project being financed, such as tolls from the toll road.
No such thing as a sure thing
Now, don't go thinking that munis are guaranteed just because governments back them. Though these bonds do have a very low default rate, there are many states and municipalities that are in serious financial trouble. (Arnold the governor ring a bell?) Investors must choose as wisely here as in all other financial arenas. Suffice it to say that if a state's best fiscal solution is to sue more money out of the tobacco companies, its best to stay away.
Some municipalities purchase insurance that will guarantee repayment of the bond if the issuer can't do it. As you might suspect, however, the yields on these bonds aren't as favorable. Guaranteed money is great, but the problem is that it doesn't pay that much in the way of return, because, well, it's guaranteed.
For that reason, you can sometimes find better deals on AAA- or AA-rated bonds, which have very little default risk but pay better rates of return.
The individual play
I'm not going to recommend any individual municipal bonds here for a couple of reasons. First, because the full tax advantage will depend on where you live, I can't recommend something that's right for a broad audience. And second, the cost of purchasing individual municipal bonds can be prohibitive for many small investors.
With that said, there are some closed-end mutual funds in this category that can make good sense for nearly any portfolio. Closed-end funds are similar to open-end mutual funds in that they're actively managed. But closed-ends trade on an exchange just like stocks, so you can buy them throughout the day, and their price is determined by supply and demand.
Your tax savior is the Van Kampen Advantage Municipal Trust II (NYSE: VKI ) . This fund has a pre-tax yield of 6.73%, but -- as with all municipal bonds -- the real value is revealed in the "tax-equivalent" yield, which is the yield a taxable bond would have to pay to equal the after-tax payment of a muni (feel free to pass out here). The tax-equivalent yield is calculated by this formula: yield divided by (1 minus tax bracket). For example, if you're in the 28% tax bracket, you would divide 6.73% by 0.72 (1 - 0.28), revealing a tax-equivalent yield on the Van Kampen Advantage Municipal Income Trust II of 9.4%. For all you fat cats in the 38% tax bracket, you'll be pulling down a mucho grande yield of 10.9%.
The fund does employ leverage to boost returns (meaning it borrows money to purchase additional municipal bonds), which adds risk. However, the overall credit quality of the fund's investments is very solid. A mere 1% of assets is invested in issues rated below investment grade.
Shares are currently trading at a 4.17% discount to their net asset value (NAV). I typically avoid paying a premium to NAV whenever possible, as there have been studies that have shown closed-ends trading at premiums to NAV tend to underperform those trading at discounts to NAV over three-, five-, and 10-year periods.
The fund has a management fee of 0.65%, well below the average for this group. However, that's only half of the expense story. The management fee is 0.45%, and the administrative fee is 0.20% (which gets us to 0.65%). But, transaction fees, which are higher on bond funds than stock funds (and higher still on municipal bond funds) drive the current total expense ratio to 1.46%. This is not great, but it's fairly typical for a leveraged municipal fund. As a matter of course, these funds raise additional investment capital by issuing preferred stock, the cost of which can inflate the expense figure.
For those of you who are used to paying lower expenses on your funds, I sympathize. In most cases, I avoid fees in this range. However, in this case, even with the higher fees associated with leveraged municipal funds, the investors who have held this security for 10 years have enjoyed yields and total returns that are several percentage points above those of typical non-leveraged muni funds.
In addition, this fund has experienced only two down years in the past 10, and the fund's current manager, Dennis Pietrzak, didn't take the reins until 1995, so we can only hold him responsible for one of them. That 15.18% loss occurred in 1999 when interest rates increased with unprecedented speed. The fund was up in each of the years following the losses, and both losses were erased within two years. So, if you purchase this security with a long-term view, you should continue to receive your substantial yield and have little concern with short-term volatility.
I first recommended this fund in 7 Paying 7, a special report for subscribers to the Fool's latest investment newsletter, Motley Fool Income Investor. The shares have climbed a respectable 7.8% since then, but I continue to believe they offer compelling value.
The Foolish bottom line
The higher your tax bracket, the more sense municipal bonds will make for you. But that doesn't mean you should ignore munis if you're not "rich." Keep a Foolish eye out, and you just might be able to find some serious bargains. The fund mentioned here is a quality, well-managed security, but the price has been volatile recently, so watch out for short-term spikes.
Another word of caution: With interest rates at these low levels, you can pretty much count on an increase at some point. Of course, no one knows when it will happen, but when it does, bonds stand to lose some principal value. That said, the yields on the Van Kampen Advantage Income Trust II and other closed-end funds are very attractive, and should increase modestly as interest rates rise. Also, the bond market losses that took place in the early '90s due to rising rates were virtually erased in one year's time. So if you keep a long-term focus, there's no reason not to take advantage of these investments as part of a diversified strategy.
Mathew Emmert doesn't mind paying taxes, as he also likes driving on paved roads. He doesn't own any of the securities mentioned in this article, but if you'd like to see what he does own, check outhis profile. The Fool has adisclosure policy.