Municipal Bonds and Physicians: 3 Considerations

I am frequently asked about the advisability of investing in municipal bonds. Usually, the investor pays no tax on the income from these bonds, and everybody loves to avoid taxes.

However, the complexity of the investment means that choosing the wrong vehicle could be a very expensive mistake.

The first choice to make is whether or not to make the investment at all. Generally, the yield on any given municipal bond (issued by some level of government and usually federal and state-specific income tax free) is supposed to result in the same "tax effective" yield as a non municipal bond of similar quality and maturity. For example, a very high quality municipal bond that will redeem in 10 years should pay an interest rate that is about 35 percent less than a similar high quality 10-year corporate bond. The taxpayer in the highest tax bracket will end up with the same amount of interest after tax. However, from time to time, this relationship goes askew. Within the last five years, there have been periods of time in which municipal bonds were paying almost the same rate of interest as their taxable competition, making them potentially the smarter buy.

The next choice on buying municipals is to buy individual bonds vs. holding a fund of many bonds. Without going into much detail, I'd strongly advise most people to buy a low-cost fund with the desired duration or maturity for the bonds inside it. Owning a fund instead of individual bonds helps avoid the high transaction costs of single-bond trading and also supplies some active management and great diversification at a small cost.

The next decision is to consider the length of time until you get back your investment. We refer to this as the maturity or duration of the bonds. The longer the duration, generally the higher the interest paid but also the higher risk of loss if interest rates go up. In an environment such as the present, in which interest rates across the spectrum are being suppressed, it appears risky to me to own any bonds of any type with other than a short duration.

So, if you wish to make a fixed income investment of a particular duration and the tax effective yield of municipals exceeds that of similar quality taxable fixed income, it is reasonable to consider a fund that owns those municipal bonds. Beware of individual bonds that are paying an interest rate that is significantly above that of other bonds-you may be buying something very risky.