This article originally appeared in Dagen's newsletter, The Save Safe Plan, which also includes a model portfolio of promising dividend-bearing stocks. For more information on this product, please click here.While Washington has passed along a nice tax cut on income, capital gains and dividends, states have been busy doing the reverse: hiking taxes. But if you want an investment that sidesteps federal, state and maybe even some local taxes, think municipal bonds. Tax-exempt bonds are historically cheap compared with Treasuries right now. Money has been flowing in Treasuries for their safety. And at the same time, the supply of municipal bonds has picked up as state and local governments try to take advantage of the low rates. The thinking used to be that you had to be in a high tax bracket in order for muni bonds to be a good investment. But these days, the yields on these securities are so close to those on taxable government bonds, munis make sense for many more people. How and why should you invest in tax-exempt bonds? Hugh McGuirk, a municipal-bond manager at T. Rowe Price, answers those questions. First, how do municipals look these days? McGuirk: Relative to Treasuries, municipal bonds are quite attractive. A 30-year municipal bond is trading at the same yield as the 30-year Treasury. And municipal bonds aren't subject to federal tax. One two-year municipal bond delivers 89% of the yield of a two-year Treasury. You're far better off in that municipal bond after taxes, regardless of your tax bracket. But there is a difference in credit quality. There is no better credit than the U.S. government. The U.S. can print money. The state of Maryland and the state of New York cannot. There's also a liquidity difference. It's easier to sell Treasuries. If you need to sell municipal bonds before maturity, a significant penalty is extracted if you're a small investor. To get an efficient price in the municipal bond market, you have to be selling in increments of a half-million dollars and higher.
What are the yields on some tax-exempt bonds compared to what you will get on Treasuries? McGuirk: Here's a bond we just bought: A 30-year, triple-A rated Texas municipal bond with a 4.3% yield and a 5% coupon. Compare that to the 30-year Treasury, which is at 4.22% yield. You're buying the municipal bond at a higher yield and it's tax exempt. If you're in the 35% tax bracket and buying a 30-year Treasury, you get left with 2.8% after taxes. Are municipal bonds right for everyone? McGuirk: Obviously, it varies based on your tax bracket. For higher tax brackets, it's a layup. But if municipal bond yields are 90% of the yields on Treasuries, which you are seeing, it doesn't take a high tax rate for them to make more sense. Should investors buy individual municipal bonds or a muni-bond fund? McGuirk: I do work for a mutual fund company. But I believe to my core that mutual funds for typical retail investors are a far better option because of the liquidity factor. You can get out of a mutual fund on any day at 100% of net asset value. When you try to sell a bond before maturity, a broker could charge you anywhere from 1% to 5%. And how would you know if you got a good price? And a managed municipal bond fund gives you diversification. If I have a more-than 2% or 3% position in one of my funds, I watch it closely. For the typical retail investor, you would need a significant amount of money to properly diversify your municipal bond holdings. How do you pick a municipal bond fund? Do you buy a broad national tax-exempt fund? Or one that's specific to the state that you live in? McGuirk: In-state funds are great, particularly in high-tax states. If I had to choose between a Maryland and a national tax-exempt fund, which would be subject to state taxes, I would look at the dividend yield of the two funds. The yield on our national fund is 4.4%. On the Maryland fund, it's 4.3%. Since I am paying 7.75% in state tax in Maryland on the income from the national fund, that ultimately gets me less yield than on the Maryland fund. And, of course, fees are important with a bond fund, especially at these low yields.