Diversify. Don't Just Invest in Municipal Bonds

Dear Dr. Don, Should I put all of my investments in tax-exempt, independent school district bonds? I am 83 years old, and I draw retirement and Social Security. -- Al Aggregated

Dear Al, As a former school district treasurer, I like the sentiment. However, I can't recommend you transfer your entire investment portfolio to tax-exempt debt issues, regardless of the issuer. I believe there's value in diversification across investments.

The municipal market that school district debt is part of allows investors to earn interest income free of federal income tax. Often, when the investor buys municipal bonds issued by a municipal issuer located in his home state, the interest income is also free of state income tax. Local income taxes also can be impacted. For example, New York residents who buy the city's municipal debt get a triple tax break because the interest income is exempt from federal, state and local income taxes.

A municipal bond fund, focused on issuers in your home state, is a way to get professional management of your municipal investment. It's likely to be the best approach for novice investors to gain municipal debt exposure. Keep an eye on the fund's annual expense ratio, and read through the fund prospectus. If the alternative minimum tax, or AMT, is a concern, then look for municipal bond funds that only invest in non-AMT bonds.

It really all comes down to your investment goals. Are you chasing yield, seeking tax-free income or concerned about the safety of principal? Municipal bonds do have credit risk that varies by issuer. Insured debt can limit that risk, but the muni bond insurance companies have had some struggles over the past four years. If you can't sort through this on your own, get some professional help from a fee-based financial planner. He or she will tell you not to put all your money into tax-exempt, independent school district bonds.

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