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After a stellar 2014, municipal-bond investors need to rein in their return expectations and reassess the risks of tax-exempt bond funds.
Last year, muni bonds were buoyed by nearly ideal conditions, including a general improvement in the financial health of state and local issuers, big tax bills spurring investor demand for these bonds, and declining interest rates. (As interest rates fall, bond prices rise.) The Barclays Municipal Bond Index gained more than 9% for the year.
Investors shouldn't expect a repeat performance this year. Prices have run up so much that there's little room for further gains, money managers say. The Federal Reserve is likely to start raising rates, casting uncertainty over all types of bond investments. And although muni default rates remain very low, negative headlines about troubled issuers, such as
That doesn't mean investors should dump muni bonds. Tax-exempt bonds help diversify a portfolio of stocks and taxable bonds. And although muni yields are low by historical standards, "relative valuations are inexpensive," says
Once you factor in munis' tax-exempt status, the comparison may look even better. With the top federal income tax bracket now at 39.6% and the introduction of the 3.8% surtax on net investment income, tax considerations are all the more important. Investors in the top federal tax brackets would have to find taxable bonds yielding well over 4% to get an after-tax yield equivalent to the 3% of the 30-year muni.
For retirees, however, the tax picture may be muddier. Muni bond income is counted when calculating potential taxation of
To get decent tax-exempt income while minimizing risk, many muni pros now recommend focusing on bonds with maturities in the 10- to 20-year range. Shorter-term bond yields aren't too enticing -- the average national short-term muni bond fund yields only about 1%, according to
Before picking a muni fund, check how it has performed during dicey periods for muni bonds. In 2013, for example,
Intermediate-term bond funds that tend to hold up relatively well in rougher markets include Fidelity Intermediate Municipal Income (symbol FLTMX) and <
With yields so low, minimizing expenses is key. The Fidelity fund charges fees of 0.36%, while the T. Rowe fund charges 0.5%. Another low-cost, high-quality fund is Vanguard Intermediate-Term Tax-Exempt (VWITX), with fees of 0.2%. Vanguard is set to introduce an even cheaper option, the Tax-Exempt Bond Index exchange-traded fund, with fees of 0.12%.
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