Question: My wife and I are in our early 60s, with a son in college. We have Roths and 401(k)s. I will get a pension from the state of North Carolina when I retire in a few years -- not so for my wife. We have $300,000-400,000 in the bank (mutual funds and tax free munis). I would like to put $200,000 into more munis. I don't think I would need the principal for, maybe, 10 years.
What I need to know is: Is there a reason not to put so much of our savings in munis? (I would take the money out of some of our mutual funds.) I would not get munis from states with problematic economies; I would most likely get them from N.C. Also, what is the best way to purchase tax-free munis? I'm expecting to get them paying, roughly, 3-4 percent returns. Is there a book you would recommend that I could study to understand tax-free munis better? Thanks! Stephen, Durham, N.C.
Answer: Tax-exempt bonds can be a good investment. My concern: Do you really want to put so much of your portfolio into a single type of investment -- especially if you put the bulk of the money into the bonds of one state, North Carolina? The point I want to emphasize is that it's important to diversify your investments, including your fixed-income investments.
To learn more about tax-exempt securities I would look at The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More, by Annette Thau. It's in its third edition. In A Random Walk Down Wall Street by Buron Malkiel, I would check out the chapter "Tax-Exempt Bonds are Useful for High-Bracket Investors." (The latest editon of the book came out in January 2011 and it remains the single best book on investing for the average person.)
In an earlier era, the muni market was a dull coupon-clipping investment for the retired elderly. It is anything but staid these days. There are risks to owning tax-exempts. State and local government finances are still under pressure. Governments around the country are struggling to deal with deficits 30 months after the official end of the Great Recession.
The good news is that the market has held up well despite forecasts of doom and gloom. For instance, well-known bank analyst Meredith Whitney gained fame (or perhaps infamy) when she predicted on 60 Minutes that there would be "hundreds of billions of dollars" in municipal defaults in 2011. Well, there have been some notable blow-ups in the tax-exempt market, but nothing even close to her predicted range. (I posted some additional thoughts of the perils of predicting market booms and busts on our Makin' Money blog.)
The tax-exempt market generated an average total return of 10 percent in 2011, according to Bloomberg News. That's better than U.S. Treasuries, corporate bonds, and the Standard & Poor's 500 over the same time period.
State government defaults are rare. For example, Arkansas was the only state to go into default during the Great Depression. It's much more common for state and local governments to have their debt downgraded. The default risks lie more with smaller issues and lower quality paper. The bigger, more common risk is credit downgrades by the rating agencies.
Individuals are snapping up tax-exempts these days for a number of reasons. The interest on tax-exempt municipal securities is free from federal income tax, and sometimes from state and local government taxes. Some people are buying munis on the expectation that federal and state taxes are heading higher. Other are buyers because yields are attractive, relative to comparable Treasuries. Munis are best for people in the highest income brackets.
I think anyone interested in buying tax-exempt securities should seek out a measure of financial safety by sticking with high quality "general obligation" (GOs) bonds backed by state and local government taxing power. With so-called revenue bonds -- issues backed by fees -- I'd stick with the debts of essential services, such as sewer treatment facilities. For most people, I think the best way to own munis is through a low-cost, well-diversified mutual fund.
Speaking of diversification, I know you're interested in sticking with securities from North Carolina, your home state. You'll give up yield buying a diversified portfolio stocked with securities from outside your state, but the portfolio will also offer an additional layer of financial safety. Again, diversification pays.