CAUTION: Not All Tax-Free Bonds are the Same

by DAVID NOVAK

If there is one constant I have found to be true across the board with
investors, it is that they don’t like paying taxes. Clients are always searching for ways to minimize or eliminate their tax obligations.

Along these lines, tax-free municipal bonds have always been sought after
because of their ability to generate income that is exempt from federal
taxes. When considering their tax-free options, I am frequently asked which
structure is better to own, municipal bond mutual funds, or the individual
bonds themselves.

The short answer is that there are benefits and drawbacks to both. Let’s
look at how they each stack up in a few key areas:

DIVERSIFICATION—This is an area where the bond mutual funds have an advantage. Most municipal bond funds own hundreds of different bonds, so an owner has exposure to different types of bonds (general obligation, revenue, etc.), but also different municipalities and different maturities. Obviously if investors choose to buy individual bonds, the onus is on them to construct a diversified portfolio.

LIQUIDITY—Open-end bond mutual funds are liquid on a daily basis; like any other open-end mutual funds, they can be bought or sold at the closing net asset value for the day. Furthermore, an investor buying $5,000 of the fund gets the same price as one who buys $50,000 of the fund. When buying individual municipal bonds, an investor often faces a certain investment minimum, which can be anywhere from $10,000 to $25,000, and sometimes even higher. Also, if
the bond needs to be sold prior to its maturity date, an investor may be disappointed in the price they get. This is because they are more than likely selling to an institution, for which a face amount of $50,000 or even $100,000
is considered to be a small amount and therefore only worthy of a “low ball
bid.

INCOME—Most individual bonds pay interest semi-annually at a fixed amount based on the bond’s coupon. By contrast, most bond funds pay interest every month, and do not pay a fixed amount; it will fluctuate with the general level of interest rates in the economy. Additionally, many investors choose to reinvest this monthly dividend back into the fund to have this money continue working for them, rather than just sitting in a cash account.

As there is much more to discuss on this topic, we will continue with
Part 2 next month.

 

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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