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Oct, 2010
Municipal Bonds: Set for a fall?

Municipal bonds have long been a popular investment, especially among higher-income taxpayers.1 Income generated by municipal bonds usually is exempt from federal taxes, and under certain circumstances can also be exempt from state and local taxes. Since the Bush tax cuts are set to expire at the end of this year -- and most federal income tax rates are scheduled to increase during 2011 -- the tax benefits of municipal bonds continue to have considerable appeal.

After the stock market began its free fall in 2007, investors looking for less risky options began pouring their assets into these vehicles. Municipal bond funds took in more than $69 billion in 2009, up significantly from $10.9 billion in 2007.2

Yet some industry experts are questioning whether munis are a "safe haven," given the heavy financial strains being felt by many municipalities. TIME magazine earlier this year warned that munis could be "The Next Financial Land Mine," and billionaire investing legend Warren Buffett has warned of a "terrible problem" facing the municipal bond market.3

So will the muni bond market be the next domino to fall? The jury is still out. Buffett foresees a crisis that could impact investors five to ten years down the road. But he stops short of predicting what the federal government might do. Some experts believe the government -- which has spent trillions bailing out private businesses and homeowners alike during this current downturn -- would step in to help local municipalities meet their obligations, particularly if a large wave of defaults begins to impact the overall economy.

The immediate future doesn't look so bleak. While municipal bond defaults had averaged about $1 billion annually in the years before the recession, they soared to $8.2 billion in 2008 and $6.9 billion in 2009. For the first six months of 2010, however, defaults have cooled considerably, totaling $1.5 billion.4

You should speak with your financial professional to help determine whether an investment in municipal bonds -- or any other type of investment -- is right for you. In the meantime, here are some points to consider.

  • If you are investing in individual bonds: Be aware of the fiscal situation of any municipality you are considering investing in, including the cities of Los Angeles, CA; Detroit, MI; and Harrisburg, PA, which are currently experiencing severe financial strain. Any bond issued by a city or state that was hit hard by the housing and job market collapse -- and is losing revenue from reduced property and income taxes -- is worth extra research. Don't just rely on credit ratings; do your homework.

  • If you are investing in a bond mutual fund or ETF: Diversification helps these vehicles lessen the impact of a single default, but diligence is still vital. While diversification does not assure a profit or protect against a loss, it can help mitigate risk. Still, it's important for prospective investors to check the overall portfolio's credit quality, average duration of the bonds in the portfolio, and the types of issues the fund manager has invested in (such as general obligation or revenue).5
1 Municipal bonds are subject to availability and change in price. They are also subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax free, but other state and local taxes may apply.

2 Source: Investment Company Institute, May 2010.

3 Sources: TIME, "Municipal Bonds: The Next Financial Land Mine," May 24, 2010; Buffett testimony to the Financial Crisis Inquiry Commission, June 2010.

4 Source: The Distressed Debt Report, July 2010.

5 Investing in mutual funds involves risk, including loss of principal. ETF prices change throughout the trading day, and investors may not be able to realize a quoted price. Purchase and sale of ETF shares may involve brokerage trading commissions that are not typically included in the ETF expense calculations. The frequent trading of ETFs could significantly increase costs such that they may offset any savings from low fees or costs. An investment in an ETF involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. Additional risks of ETFs include lack of diversification, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking error.

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©2010, Kelly Ruggles, Spokane, WA. Web site
Kelly C. Ruggles, Spokane, WA. is a fee-based financial planner located in Spokane.
Kelly C. Ruggles, Spokane, WA. President of American Reliance Group, Inc., a registered investment advisor.
Kelly Ruggles, Spokane, WA. is the author of "The Financial Playbook" for Retirement

Kelly C. Ruggles, Spokane, WA. Does not intend to provide personalized investment advice through this publication and does not represent the strategies or services discussed are suitable for any investor. Investors should consult with their financial advisors prior to making any investment decisions.