March 26, 2007

A Tax-Free Approach to Investing

Muni bonds may be the way to go

For tax-exempt income, consider muni bond funds.

Standard & Poor's advocates diversity, especially in terms of asset class. To that end, we recommend a portfolio of 40% U.S. stocks, 20% foreign shares, 25% bonds, and 15% cash.

Investors can construct the equity portion using our stock screens and proprietary portfolios like Neural Fair Value 25. But what's the best way to build out your bond holdings? One way is to invest in individual corporate bonds. Taxable bond funds might also be considered. But many investors derive considerable benefit from stocking the bond portion of their portfolios with municipal bonds -- securities issued by state, city, or local governments, and associated agencies.

"The single most important feature of muni bonds is the tax-exempt status they hold," says Dan Loughran, a portfolio manager and the team leader of Oppenheimer Funds' 18 tax-free bond funds. "And compared with taxable bond products, munis almost always look better on an after-tax basis." Loughran says that to outpace a 4.5% yield on tax-free bonds, an investor in the 28% tax bracket would have to earn 6.4% on a similar taxable product. According to Fidelity Investments, municipal bonds have outperformed taxable bonds on a pre-tax basis over the past five years. For the one-, three-, and five-year periods ended December 31, 2006, the Lehman Brothers Municipal Bond index had annualized returns exceeding the broad-based Lehman Brothers Aggregate Bond index by 0.50%, 0.58%, and 0.47%.

A key advantage of a tax-free bond fund over an individual muni bond is the professional oversight a portfolio manager brings to the picture. This professional can provide a level of diversification within the fund that an individual would be hard pressed to match with a limited dollar investment. Funds often offer higher yields than single issues, and fund managers can switch in and out of positions. An investor trying to unload bonds in the market might run into liquidity problems.

So what type of investor is best suited to tax-free funds? Dick Berry, a senior portfolio manager of two tax-free funds at AIM Capital Management, says these funds are well suited to baby boomers, who are moving from wealth accumulation to investments that generate income.

Mark Sommer, a portfolio manager of several tax-free funds at Fidelity, says muni funds have broad appeal for people in higher tax brackets, but they are just as much about diversification as income generation. Although it's typical for older people to have more of their portfolios in bonds, the main issue is an investor's risk tolerance, says Oppenheimer's Loughran.

"The ultimate answer to that is a personal one," he says. "I was all equities in my 20s, but for someone else, bonds may work. And if they're looking at bonds, then tax-free bonds might work." As with any asset class, it's important for an investor to do some homework, and the research capabilities of a bond fund's staff should be a focus. Also, it's key to find a manager with a proven record of managing money in a variety of circumstances, Sommer says. Make sure to select a fund with low fees; Sommer says they can be the key to long-term performance.

And it's increasingly important for investors to ascertain whether they're exposed to the alternative minimum tax (AMT), a complex set of tax rules requiring more Americans each year to pay extra taxes on income. A tax professional can help an investor determine AMT status.

"It depends on what deductions they take and which state they live in," says Loughran of Americans socked by the AMT, adding it's particularly germane to investors living in high-tax states like California and New York. "If you are subject to AMT, you should avoid bonds or bond funds subject to the tax." While most munis are not subject to the AMT, some are -- namely, private activity bonds. These securities are issued by a public entity but fund a private purpose, such as a stadium or a hospital. All bond funds must disclose in their prospectuses whether the bonds they invest in are subject to the AMT.

Some of AIM's funds have invested in bonds that can trigger the AMT, and when those mature, they won't be replaced with similar bonds, Berry says.

There are also funds that are AMT-free; the Oppenheimer AMT Free National (OPTAX) is one. Fidelity also offers several AMT-free products.

"The approach we've taken in our funds is consistent with the approach we've taken across the board," Fidelity's Sommer says. "We're total return oriented, not yield oriented, and we're not avoiding bonds subject to AMT. We buy the cheapest AMT bonds we can, and hope they outperform from a price standpoint and offset some of the taxes they can incur."

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