CAUTION: Not All Tax-Free Bonds are the Same–Part 2

by David Novak

Last month we discussed the differences between tax-free individual
municipal bonds and municipal bond mutual funds. While we compared
them on the basis of diversification, liquidity, and income, there are other factors to take into account when considering these investments.

This is 
an area where the bond mutual funds
can add value, as they are able to gain
access to individual new issues of
bonds that many retail investors cannot.
When buying individual municipal
bonds, investors are basically limited
to the bonds available at the brokerage
firm or custodian where they have
their accounts. Often this selection is
limited, both in number of bonds and
size of each bond available.

As with all investments,

there are costs involved, whether you
see them or not. With bond mutual
funds, there is an internal expense ratio,
which is essentially how much it
costs to operate the fund on an annual
basis. Additionally, depending on
how your advisor is paid, there may
be a sales load involved based on the
share class of the fund. When buying
an individual bond in a commission
account—where the vast majority of
them are sold—the advisor’s compensation
is embedded into the price of the
bond. So, if the base cost of the bond is
100 cents on the dollar, and the advisor’s
commission is 2.5 cents, the net
price you will pay is 102.5 cents on
the dollar. Often the trade confirmation
will only include this net price, so investors
are not aware of the true costs
they are incurring.

In many ways, this is the biggest difference
between individual bonds and
bond mutual funds. With an individual
bond, there is a fixed maturity date
when all investors will receive their
principal back. This means that the exact
total return, or yield to maturity, is
known at the time of purchase. There
is no maturity date for bond mutual
funds, making the effect of changes
in interest rates much more important,
since bond prices move in the opposite
direction of interest rates. Consequently,
in a rising interest rate environment,
even a very good bond fund can have
years where it loses money.

Keep in mind that this series is not meant to advocate one type of tax free
fixed income investment over another, but rather to highlight some topics
to evaluate when considering these types of investments.

David Novak, CFP® is a Certified Financial Planner™ at 
Novak & Powell Financial Services in Pinellas County.
Please note: he is not an attorney and this article
should not be construed as one offering legal advice.
For information about investment decisions and
financial planning, contact him at (727) 451-3440.


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