A Tax-Free Approach to Investing

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.