Monday, April 06, 2009

Fundline: Tax-Free Bonds Out-Yield Taxable Bonds


In the normal course of events, tax-free municipal bonds usually yield less than taxable bonds. But the financial world is turned upside down, and non-taxable bonds now offer tastier yields.

All bonds are interest-paying IOUs, and the amount of interest they pay depends, in large part, on their creditworthiness. An issuer teetering on the edge of bankruptcy will pay far more interest than the U.S. Treasury, which can raise taxes or even print money in a pinch.

Cities, states, towns and other municipal entities issue bonds to pay for schools, roads and other projects. The interest these bonds pay is exempt from federal tax — and state tax, too, for bondholders who live in the issuing state.

Because munis have a big tax advantage, they almost always yield less than taxable bonds, such as Treasury securities. Someone in the 33% tax bracket, for example, would have to earn 3.8% in a taxable bond to get the same after-tax return as a 2.6% tax-free bond. (If you want to calculate a muni bond's taxable-equivalent yield, has a calculator.)

But the global financial crisis has sent investors scrambling into ultrasafe Treasury securities, pushing yields down. A 10-year T-note, for example, yielded just 2.90% Friday. A 10-year, highly rated municipal bond yielded 3.44%.

Why? Big investors haven't scrambled to munis, in part because most institutional investors don't give a hoot about taxes. Munis aren't backed by the full faith and credit of the U.S. Treasury, meaning there's a chance a muni bond could default.

But states and towns can raise taxes to meet debts, and muni bond defaults are extremely rare. If you're looking for high yields and low taxes, munis look like one of the best deals out there.

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