Municipal bonds: the choice of wise investors.

• Author: Gallea, Anthony M.
• Position: Personal Financial Planning

When Presidential candidate H. Ross Perot disclosed details of his investment portfolio, as required by law, they reflected the holdings of a successful entrepreneur. As expected, they included high-tech stocks and venture capital investments. Many observers were surprised, however, to find that Mr. Perot's bedrock investment of choice was municipal bonds.

What prompts this savvy capitalist to find municipal bonds attractive? And how can you fit them into your own investment strategy?

FACTS AND FEATURES

Municipal bonds are issued by state and local government entities: cities, towns, water districts, state agencies, industrial development authorities. The basic denomination for purchase is $5,000.

Most municipals fall into two broad categories--general obligation and specific-use.

General obligation (GO) bonds are supported by the issuer's full taxing authority. Theoretically, a state could raise taxes as needed to service its GO bonds. For this reason, many conservative investors prefer GOs. Of course, the additional implied safety means the yield paid is a bit lower than on other bonds of equal credit rating.

Specific-use bonds are backed by a limited source of revenue, such as bridge tolls and water bills. Because these bonds aren't guaranteed by an issuer's full taxing authority, many investors assume they carry higher risk. But, in the municipal bond market, differences in risk are small indeed and are often more theoretical than real. For instance, if bridge toll revenue is inadequate, the state is not likely to let the bondholders eat a loss, because the state knows it will have to borrow again for new bridges.

Municipal bonds are attractive to investors for a number of reasons. First, they carry a unique and compelling feature: The interest they pay is free of federal income tax. And if you purchase a bond originating in your state of residence, it's also free of state income tax. This two-pronged tax relief provides plenty of incentive to consider these debt obligations.

Second, as government issues, municipals have enjoyed a nearly default-free history. They've defaulted in less than one-tenth of 1 percent of all instances, and these defaults are generally limited small, specific-purpose bonds in isolated cases.

Third, like other types of bonds, municipals are usually assigned ratings by Standard and Poor's, Moody's, Fitch's and others to help investors judge the quality of the bond. The absence of a rating, however, doesn't automatically mean the bond is of poor quality. Sometimes a credit-worthy issuer, such as a school district, is too small to pay for a credit rating...