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Tax exempt bond funds

Chris Farrell Oct 6, 2008

Question: Almost all of my fixed income holdings are in municipal bond funds, since my wife and I are in the 28% tax bracket. I’m wondering about the safety of municipal bonds at this time, given the current economic environment, and whether we would be better off diversifying into government short or intermediate term bond funds. Any thoughts you have about this matter would be greatly appreciated. Larry. Hurleyville, NY

Answer: The 13-month old credit crunch has taken its toll on tax exempt bond funds. The state of California is facing a cash crunch, and may need a $7 billion federal bailout. (Isn’t it amazing how we’re just tossing around the term “billions”?) New York City plans to cut its budget. States and localities across the country are dealing with declining revenues, and the fiscal situation will only worsen as the economy sinks into recession. Many economists are changing their forecasts for the economy. They’re predicting a higher unemployment rate and a lower GDP number than before. Investors are fleeing even high quality munis for the safety of U.S. Treasury securities. According to the mutual fund rating service Morningstar, muni bond funds are in the red, with the typical fund down 5.6%. Much of that decline has happened over the past year.

There is another factor haunting the market: The unthinkable is increasingly thinkable. Default rates have been low in recent decades in the state and local government tax exempt market. Yet this credit crunch has overturned many historically based rules-of-thumb. The combination of a recession and credit crunch could drive the muni default rate higher. Are muni’s less safe than recent experience would suggest?

Troubling questions like this and the worsening fiscal situation are behind some crazy moves in the market. For example, investors are pocketing a higher yield from tax-exempt money-market mutual funds than from their taxable counterparts. Normally, tax-exempt yields are lower than taxable yields, since the tax hit is so much less. Money market funds that invest only in short-term U.S. Treasuries yield about 1.5% compared to a yield of about 5% or more on tax-exempt money market funds. So an investor in the 35% federal tax bracket filing jointly and paying what the Tax Foundation calculates is an average 9.7% state and local tax burden (since the securities come from municipalities around the country) earns somewhere around a 5% yield on the tax-exempt fund compared with around 1% on the taxable money market Treasury fund. In the 28% tax bracket the taxable yield jumps to 1.08%.

What to do? I know a number of smart people who are putting some of their risk money into high-quality tax exempts, especially into tax exempt money market mutual funds (and the tax exempt money market mutual fund money that was invested before September 19 comes under the Treasury’s new stabilization fund program). These investors believe the risk is worth the reward. They are comfortable with the risk..

Your investment issue isn’t a case where I can easily tell you to “do this, but don’t do that”. Instead, here’s my advice for a portfolio issue like yours: Make sure that you’re in the conservative portion of the tax exempt universe.

It pays to stay with high quality in the municipal bond market (as well as the corporate bond market), even though yields are lower. Safety matters. That’s why diversification also pays. I like tax exempt funds that invest around the country rather than in one locality–even though that means you give up some tax advantage. The added protection is well worth the small tax hit you’ll pay.

Larry, I am a strong believer in diversifying down to the sleeping point. If you’re comfortable with your fixed income portfolio after thinking it through, fine. If you are still worried, then diversify into Treasuries–enough so that you can relax

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