Ask Money

Tax exempt bonds

Chris Farrell Feb 1, 2010

Question: I’m in my mid 50’s and have extra money to invest after maxing out my 403b, etc., so I’ve been thinking of putting some in tax free state or municipal bonds. But I don’t live in a financially prudent state but in New York, which is apparently going down the tubes completely if I believe what the governor is saying. Of course some other states are even worse.

Are there tax-free bonds that are designed to pay back the bondholders in some reliable way even if the state itself goes into default (e.g., a bridge that’s contracted to pay its bondholders through its toll collections?) Or do people in New York, California, etc., just have to hope for the best when we buy our states’ bonds? Michael, New York, NY

Answer: You’re right to be concerned. The Great Recession may be over, but state and local government finances continue to deteriorate. California, the eighth-largest economy in the world, keeps treading on the edge of fiscal disaster. Nine other states aren’t in much better shape, according to a recent study by the Pew Center on the States. Even after taking into account aid from Washington, state governments face a combined projected budget deficit of $350 billion over fiscal years 2010 and 2011, according to the Center on Budget & Policy Priorities.

That said, tax-exempt bonds have been doing well over the past year. (The previous year was a disaster.) One reason why individuals are snapping up munis is a widespread expectation that federal and state taxes are heading higher. Muni yields are also attractive relative to comparable Treasuries, especially for those in top tax brackets.

Still, what about those yawning budget deficits and fiscal turmoil? State government defaults are rare (Arkansas was the only state to go into default during the Great Depression). A number of states have had their debt downgraded, and more is likely to come. The default risks lies more with smaller issues and lower quality paper. However, even with high quality securities I expect a lot of volatility.

So, I would seek a measure of safety by sticking with high-quality general obligation bonds, which are backed by the taxing power of the issuer. When buying revenue bonds, which are supported by fees, investors are seeking out bonds backed by revenues from so-called essential services, with the classic examples being water and sewer bonds. And, even though you will give up some tax shelter, what about a tax exempt mutual fund that owns munis from around the country? It will diversify away some of the risk of default.

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