TAKE NOTE feature

Finding Tax Advantages in
Municipal Bonds

The changes in tax law made earlier this year have prompted many investors to consider the benefits offered by municipal bonds.

fter Congress raised federal income tax rates on top incomes in January, more investors sought out ways to reduce their tax liability. This trend has accelerated demand for municipal bonds, which generate semiannual tax-free interest payments. While some investors have focused primarily on that tax advantage as a reason to invest in muni bonds, it's important to avoid making investment decisions solely based on tax considerations and to understand all the factors that influence municipal bond returns. Says Hugh McGuirk, head of municipal bond investing at
T. Rowe Price, "Tax and public policy is only one of four main drivers of municipal bond performance."

State and local governments issue municipal bonds to fund general spending needs or to finance special projects. General obligation municipal bonds are backed by the taxing authority of the issuing government, while revenue bonds pay back investors from revenue generated by the project, such as a highway construction bond that is serviced by toll collections. Interest generated by both types of bonds is free from federal taxes and possibly from state and local taxes.

FOUR FACTORS. To assess the current and long-term prospects for municipal bonds, investors should consider the following four factors. McGuirk notes that all four are currently favorable to investors, but changes in any one of them could cause market volatility.

Technical market conditions, such as supply and demand, influence municipal bond prices and yields. Demand for munis is rising at a time of tightening supply. McGuirk expects net new supply will be low again in 2013, as more existing bonds reach maturity or are refinanced to take advantage of low interest rates. He believes this trend will support the muni market in the near term.

Tax and public policy also play a significant role in muni bond returns. Tax increases raise the appeal of municipal bonds relative to taxable bonds. Other policy changes can depress demand and cause muni bond prices to fall. For example, late last year Congress considered limiting the tax exemption on municipal bond interest. If a proposal of this type were ever passed in the future, it could diminish investor enthusiasm for municipal bonds.

Fundamental economic factors can influence tax receipts and thus affect the fiscal health of municipalities. McGuirk believes that most municipalities are stable, reliable, resilient, high-quality issuers. They must balance their budgets annually, and they have adjusted their expenditures in recent years to accommodate revenue shortfalls. However, he acknowledges that there will be instances when some municipalities with management-related fiscal problems that have been exacerbated by economic factors could make headlines and have a short-term negative impact on the muni market.

Yields on U.S. Treasury bonds also affect municipal bond performance. When the yield on a U.S. Treasury security is significantly higher than the yield of a muni bond with a comparable duration (a measure of its interest rate sensitivity), investors often prefer the higher pretax income and relative security of Treasuries over the tax benefits of munis. Conversely, a tight spread should prompt investors to favor the higher after-tax income of municipal bonds. The recent spread between Treasury yields and the yields on comparable municipal bonds was small by historical standards.

Assessing these market factors and analyzing the fundamental strengths of muni bond issuers can be a complicated process. Investing in mutual funds can be a simpler way to take advantage of the potential tax benefits and diversification offered by municipal bonds. "The key," McGuirk says, "is to analyze muni bonds carefully to avoid the weaker issuers. Good credit research is our best defense."

Municipal bond funds make it easier to achieve diversification in this market. Funds typically hold a wider range of bonds than individuals can purchase on their own. This can help reduce volatility related to any one issuer. Investors also can assemble a fund mix of bond types and maturities, such as state or federal muni funds and short-, intermediate-, or long-term holdings. Of course, diversification cannot assure a profit or protect against loss in a declining market.

Mutual fund investors also can rely on professional managers and analysts to perform the credit research that is vital to reducing risk. T. Rowe Price's municipal bond team employs eight credit analysts whose research often includes site visits to assess the potential for municipalities to meet their obligations. They also study economic factors and other underlying market conditions to help identify good values in the bond market and to assess when it makes sense to buy a lower-rated credit to obtain higher yields. Their judgment can help investors target higher long-term returns than they might feel comfortable pursuing on their own.

Municipal bonds may have a place in your taxable investment portfolio. "There's always room for fixed income in a diversified portfolio," says McGuirk, "and you can benefit from deriving a portion of that fixed income from tax-free municipal bonds, especially if you're in a high tax bracket."

Yield and share price will vary with changes in interest rates and market conditions. Investors should note that if interest rates rise significantly from current levels, bond fund total returns will decline and may even turn negative in the short term. Some income may be subject to the federal alternative minimum tax.

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