Last year was a good one for municipal bonds. Their average after-tax yields exceeded those of Treasuries by at least 1 ½ percentage points.
In addition, longer maturity munis yielded 0.5 percentage point more than bonds with shorter maturities, rewarding long-term investors.
That didn't happen with Treasuries, where yields on short-term bonds exceeded those of longer-term bonds for much of the second half of 2006.
Once seen as a tax shelter for the wealthy, muni bonds can be attractive for people in most tax brackets.
It's easy to compare yields. For example, to see if a muni bond yielding 6 percent is better than a taxable bond, subtract your marginal tax rate, say 35 percent, from 1. Use that number (0.65) to divide 6 percent, the yield of the tax-free bond.
The result is 9.2 percent — the yield a taxable bond would have to pay to equal that of the muni, on an after-tax basis.
Residents of high-tax states, such as Massachusetts, New York and California, benefit most from state-specific bonds or bond funds.
This year should again be strong for munis, according to Philip Fischer, head of municipal-bond research at Merrill Lynch.
The credit standing of most state and local governments remains high. Bond issuance by states and municipalities should remain near 2006's high levels. But investor demand should continue to meet supply, so bond prices shouldn't suffer.
"When the Congress is in a position of trying to balance the budget, they're going to be quite sensitive to what they do to state finances," Fischer says.
Sources: Morningstar, Thomson Financial, Merrill Lynch & Co.
