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Municipal Bonds: This Year's Hottest Investment Strategy

The unsexy municipal bond is the year’s hottest investment strategy.
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Usually around this time of year, according to Alfred, Lord Tennyson, a young man’s fancy lightly turns to thoughts of love. The great British poet was apparently unaware that by April 15 you have to file your taxes. Of course, this means that any illicit or obscene thoughts dancing in your head are probably directed at the Internal Revenue Service.

But there is one promising way, right now, to simultaneously boost your wealth and get your revenge on the IRS: Invest in municipal bonds. If you don’t know what those are, hang in there, I’m about to explain it to you. But know that the revenge part is real: You pay zero tax on the interest earned from muni bonds. (Fancy that? Thought so.) And the wealth part is real, too: The experts agree that muni bonds have become one of the surest investments in finance.

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A bond is an investment in which you lend money in return for interest. (Sort of the opposite of a mortgage.) When you buy munis, you’re effectively lending money to cities, towns, or states, which use the money to build bridges or airports or football stadiums. They pay you back with interest, and Uncle Sam doesn’t tax those payouts. Why not? Because, since investors are getting a tax benefit, they usually accept lower interest payments, and that ultimately saves the municipality money.

But recently, tax-free muni bonds have been paying higher yields than the taxable bonds issued by the Federal Treasury. Historically, that’s a rare reversal, and it means you earn more but pay less in taxes. It may be as close as you’ll ever come to being Mitt Romney.

This unusual situation began with the financial crisis, when investors were running so scared they dumped everything except for Treasury bonds, which are seen as “risk free.” Munis recovered somewhat but then got hammered again in 2013 for two reasons. First, interest rates rose, which reduced the value of older, lower-yielding bonds. Second, the Detroit bankruptcy and a growing financial crisis in Puerto Rico spooked municipal bond investors. As a result, investors pulled about $60 billion from muni mutual funds last year. And the time to buy an asset is when everyone else is selling.

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