Municipal Bonds May Be Good for Your Portfolio
By Saghir Aslam
Irvine , CA
(The following information is provided solely to educate the Muslim community about investing and financial planning. It is hoped that the ummah will benefit from this effort through greater financial empowerment, enabling the community to live in security and dignity and fulfill their religious and moral obligations towards charitable activities)
If your investment portfolio consists of only equities, you may want to diversify. Stocks and other equity securities are an important part of your investment mix, but you may also want to consider some fixed income investments like municipal bonds. Income is generally free from federal taxes and state taxes for residents of the issuing state, however capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT).
When you purchase a new-issue municipal bond, you actually make a loan to the issuer, which may be a city, township or school district, for example. These entities use the funds raised from the sale of bonds to finance new streets, water and sewage systems, hospitals, parks, and many other improvement projects. In return for the use of your money, the issuer promises to pay you not only the principal amount back when the bond matures, but also a set interest rate, or coupon, during the term of the bond.
For many investors, the most favorable aspect of municipal bonds deals with the federal-tax-free income they offer. Investments must offer a substantially higher rate of return to be able to match the after-tax return available on a municipal bond. For example, if you are an investor in the 33% income tax bracket, you would have to find a taxable bond paying 7.46% to achieve the same after-tax return as what you would get from a municipal bond yielding 5%.
High-quality municipal bonds also provide a range of interest rates at various maturities, to help you plan for short-term or long-term income needs. To illustrate, if municipal bonds priced near par value were providing coupon rates ranging from 2% to as much as 5%, you would receive from $20 to $50 per year federally tax free for each $1,000 principal bond you own. Depending on which bonds you choose, you can plan for income now and in the future as municipal bonds are issued with various maturities ranging from one to 30 years.
It is also important to note that municipal bonds typically have very low default rates. According to the Bond Market Association, less than 1 percent of municipal bond issues sold since 1940 have gone into either technical or actual default. However, past performance does not guarantee future results. Municipal bonds are also usually issued with a credit enhancement, such as bond insurance or a bank letter of credit, which helps provide a stronger assurance of timely payments.
Some important points to remember: Yields and market values will fluctuate if the bonds are sold before maturity. Bonds are subject to market risk and, if sold prior to maturity, may be worth more or less than their original cost. Investors should keep in mind that as interest rates rise, existing bond prices of already outstanding fixed income securities tend to fall. Long-term bonds are generally more exposed to interest rate risk than short-term bonds.
Now that you are considering greater diversification within your portfolio with some fixed income investments, it is also important to realize that you can find a lot of diversification just among municipal bonds themselves. This is because they are a major means of financing growth and expansion in a wide variety of communities and are issued in all parts of the United States. This provides you with a large selection of bonds from which to choose. In addition to geographic diversity, you will find an array of maturities, prices, coupon rates and other features that may be a good fit for your future needs.
Working with your Financial Advisor, you can determine whether municipal bonds make sense for you when considering your tax situation, objectives and tolerance for risk. Your Financial Advisor can help you choose bonds that are not only a good fit, but may also give you the opportunity to support projects within your community.
(Saghir A. Aslam only explains strategies and formulas that he has been using. He is merely providing information, and NO ADVICE is given. Mr. Aslam does not endorse or recommend any broker, brokerage firm, or any investment at all, or does he suggest that anyone will earn a profit when or if they purchase stocks, bonds or any other investments. All stocks or investment vehicles mentioned are for illustrative purposes only. Mr. Aslam is not an attorney, accountant, real estate broker, stockbroker, investment advisor, or certified financial planner. Mr. Aslam does not have anything for sale.)