Not just for the wealthy

NEW YORK – Municipal bonds might seem best suited for the most conservative investors and retirees, but the tax benefits of these debt instruments should make them attractive to a much broader audience.

Municipal bonds – essentially the local equivalent of U.S. Treasuries – may not be the sexiest of assets, but they can be a real wealth builder for patient investors, particularly those living in states with high tax rates such as California, Connecticut, Pennsylvania and New York.

“It doesn’t matter your age so much as your tax bracket. I think even in the smaller tax brackets, munis can make a lot of sense,” said Hugh McGuirk, head of the municipal bond department at T. Rowe Price. “Fixed income wasn’t very popular in the late ‘90s, but if you look at returns over the last five years, municipal bonds have been one of the best-performing assets available.”

Building a portfolio of individual muni bonds would be a huge challenge for a small investor, so mutual funds are a wise choice, McGuirk and other experts said. With funds offered by most of the major shops, a wide range of choices are available, focusing narrowly on single states and maturities, or more broadly on municipal debt due in varying stages across the nation.

In addition to diversification, the biggest advantage funds have over individual bonds is liquidity, said Robert R. Johnson, managing director of the CFA program division at the CFA Institute, a nonprofit group based in Charlottesville, Va., that certifies financial analysts. Many municipal bonds are thinly traded, and if an investor wishes to sell before maturity, they’re likely to get back much less than he or she would for similarly rated, more actively traded bonds. That means if you do own individual bonds, unless you’re a sophisticated investor, you should plan to hold them until maturity.

Since tax efficiency is their primary benefit, it doesn’t make a whole lot of sense to hold municipal bonds in a tax-exempt portfolio such as a 401(k) or an individual retirement account. However, there are a number of ways small investors can put munis to work, said Andrew Clark, bond analyst at fund tracker Lipper Inc.

For example, if you are saving for a child’s education, when he or she becomes a teenager and school is just a few short years away, it might be wise to plunk those savings into a muni bond fund where they can continue to earn interest, but not incur taxes.

“Why should your daughter be paying taxes at 16 on the $100,000, $200,000 or $300,000 you saved for her education? There’s no reason. At least tax defer some or all of that,” Clark said. The same strategy could be employed for a person who has been building up a retirement nest egg in a taxable account, he added.

“These really are the hidden gem of the bond fund world,” Clark said, noting that during the bull market for stocks, many investors neglected tax issues in planning their portfolios.

Perhaps because the market for municipal bonds is more local in nature than it is for other types of fixed income securities, muni bonds tend to attract the most individual investors. Some two-thirds of the muni bond market is held by individuals, both by direct ownership and through mutual funds, said Michael Decker, senior vice president of the Bond Market Association. By comparison, individuals account for just 15 percent of ownership of corporate bonds, Decker said.