Time To Go Tax Free?

8/20/2012


The appeal of municipal bonds is obvious — income paid on the bonds is typically exempt from federal taxes and often exempt from state and local taxes. Now municipal bonds also offer particularly attractive yields, even for investors in low tax brackets. And with income tax rates potentially on the rise at the end of the year, municipal bonds might ease the pain of any tax hikes.

Because of their tax advantages, municipal bonds have typically had lower yields than corporate bonds. However, the Bond Buyer 20 GO Index, which tracks 20 municipal bonds, yields roughly 3.8% while high-quality corporate bonds yield 3.4% and 10-year Treasury bonds yield just 1.7%. For an investor in the 28% tax bracket, a 3.8% municipal yield is equivalent to a taxable yield of 5.3% — nearly two percentage points above corporate bonds.

Municipalities mostly issue general obligation (GO) bonds backed by tax revenue. But depressed property values, high unemployment, and sluggish income growth have slowed tax streams. Moreover, pension obligations and large debt loads have strained some municipalities and raised concerns about bond defaults.


Top municipal bond funds

• T. Rowe Price Tax-Free High Yield ($12; PRFHX)
• Vanguard Intermediate-Term Tax-Exempt ($14; VWITX)
• USAA Tax Exempt Long-Term ($14; USTEX)
• USAA Tax Exempt Short-Term ($11; USSTX)


Despite some recent high-profile municipal defaults, the overall default rates on general obligation bonds remain quite low. Yet the heightened anxiety has led to outsized yield spreads. Since 2000, municipals on average have yielded one percentage less than corporate bonds. Today, municipals yield roughly one-third of a percentage point more than corporate bonds.

Investors looking to exploit the wide yield spread should consider Vanguard Intermediate-Term Tax-Exempt ($14; VWITX). The fund, which focuses on high-quality bonds, yields 3.2% and has a taxable-equivalent yield of 4.4%, assuming a 28% tax rate. Risk-tolerant investors seeking higher yields might consider USAA Tax Exempt Long-Term ($14; USTEX), which holds high-quality bonds and yields 4.1%, and T. Rowe Price Tax-Free High Yield ($12; PRFHX), which invests in lower-rated bonds and yields 4.4%. Conservative investors should consider USAA Tax Exempt Short-Term ($11; USSTX), which yields 2.3%.

OUR RECOMMENDED MUTUAL FUNDS
Through Aug. 14, our recommended Growth Portfolio has gained 9.8% so far this year, versus a 10.6% gain for its benchmark portfolio. The Conservative Portfolio is up 9.2%, versus 8.4% for its benchmark.
-- Year-To-Date --
--- % Of Portfolio ---
 
Fund (Price; Ticker)
Return
(%)
Rank
Conser-
vative
(%)
Growth
(%)
Fund
Rating
Dreyfus Midcap Index ($28; PESPX)
9.5
C
0
0
81
Dreyfus Small Cap Stock Index
($21; DISSX)
8.7
B
0
0
95
Fidelity High Income ($9; SPHIX)
9.9
B
5
5
88
Homestead Small Company
($25; HSCSX)
10.8
A
7
8
98
Manning & Napier International
($8; EXITX)
4.3
E
7
7
56
T. Rowe Price New Horizons
($35; PRNHX)
12.8
A
10
10
100
Vanguard 500 Index ($130; VFINX)
13.1
B
6
7
81
Vanguard Dividend Growth
($17; VDIGX)
8.9
E
12
12
100
Vanguard Emerg. Mkts. Stock Indx.
($26; VEIEX)
8.2
C
0
4
76
Vanguard GNMA ($11; VFIIX)
1.9
C
5
4
93
Vanguard Growth Index
($36; VIGRX)
14.8
A
12
12
98
Vanguard Inter.-Term Tax-Exempt
($14; VWITX)
4.1
B
0
0
67
Vanguard Selected Value ($20; VASVX)
8.0
D
5
6
93
Vanguard Short-Term Invest.-Grade
($11; VFSTX)
3.0
B
0
0
86
Vanguard Total Bond Mkt. Index
($11; VBMFX)
3.0
E
9
0
53
Vanguard Total Int'l Stock Index
($14; VGTSX)
7.1
D
5
4
63
Vanguard Wellesley Income
($24; VWINX)
7.9
A
0
0
100
Vanguard Wellington ($34; VWELX)
9.0
B
6
9
93
Wasatch International Growth
($21; WAIGX)
17.2
A
5
5
94
Wells Fargo Advantage Discovery
($26; STDIX)
11.5
B
6
7
89
* Year-to-date ranks through Aug. 14from Morningstar, comparing performance among funds with same objectives. A = top 20%; B = next 20%; C= middle 20%; D = next 20%;
E = bottom 20%. Fund ratings are percentile ranks based on our fund-rating system.

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