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Municipal Bonds: This Year's Hottest Investment Strategy

The unsexy municipal bond is the year’s hottest investment strategy.

As other investors have fled, fee-only financial adviser Gary Schatsky has started recommending munis to clients, especially high earners—the higher your tax bracket, the bigger the benefit of tax-free income. He says munis have been “unfairly tarred” by the problems in Detroit, which means investors are buying low. “The added upside is obvious,” Schatsky says. “You save a substantial amount on taxes.” Other smart investors have been singing the praises of munis recently as well, including Burton Malkiel, whose book A Random Walk Down Wall Street is one of the most influential investing books of the past century.

Municipal finances, meanwhile, are actually getting healthier. Unlike the federal government, state governments are required to balance their budgets every year. In fact, 14 states have a triple-A rating, an honor the dysfunctional federal government lost in 2011.

Now, to be clear, you’re not going to shoot the lights out by investing in muni bonds. Munis will pay you 2.5–4.5%, and you might do a little better if the value of the bonds appreciates. But before you scoff, keep in mind: That’s a tax-free 4.5%. You keep it all. Virtually every other cent anyone pays you, whether it’s your boss, your bank, or an investment, gets cut by 20 or 30 or 40% on its way to your checking account. If this were a regular bond, it would have to pay an interest rate around 6.7% (depending on your tax bracket) in order for you to pocket the same amount of money. If you live in a city such as New York, with high state and local taxes, you’d have to earn more than 8% just to keep 4.5% after taxes. Good luck finding an investment as safe as a muni bond that will pay you 8%.

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So, how to invest? The first question is whether to buy individual bonds or a mutual fund that holds lots of them. Most experts say you need close to $1 million to properly diversify a portfolio of individual bonds. So unless you’ve got a cool mil to invest, funds are the way to go.

Consider three types: A core fund that holds a broadly diversified mix of bonds from around the country; a closed-end fund, which can offer higher returns if you’re willing to take the extra risk; and a state-specific fund, which is worth a look for residents of high-tax areas. You may even want to spread your cash among all three. Keep in mind that you can lose money in these funds, especially if interest rates rise.

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