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By Christine Benz and Miriam Sjoblom, CFA | 04-15-2013 12:00 PM

What to Look For With Muni Funds

Morningstar's Miriam Sjoblom discusses how to gauge whether a muni fund is more apt than a taxable-bond fund, yield risks and other key focus points, and some of her muni-fund recommendations.

Christine Benz: I'm Christine Benz for How do you know if municipal-bond funds belong in your toolkit, and what should you look for if they do? Joining me to address those questions is Miriam Sjoblom. She is associate director of fund analysis with Morningstar.

Miriam, thank you so much for being here.

Miriam Sjoblom: Good to be with you.

Benz: Miriam, I would like to start by talking about the tax case for municipal bonds. How do they work in terms of the tax savings?

Sjoblom: Well, the big advantage for municipal bonds is that if you own a municipal-bond fund in your taxable account, the interest income is not subject to federal income tax.

Benz: So, that's a big advantage, and there are also potentially state and local tax advantages as well.

Sjoblom: Correct.

Benz: Let's talk about how to do that calculation, about whether a municipal-bond fund or bond is indeed a better fit for you than a taxable bond or bond fund. How should investors think about that particular question?

Sjoblom: So, there is pretty simple calculation that an investor can do, and it involves creating the taxable equivalent yield from municipal a bond yield. So, you would take the yield of the muni investment that you are looking to invest in and divide it by 1 minus your tax rate. And that gives you what's called the taxable equivalent yield that you can then compare with a taxable investment to see does this makes sense for me to be in a tax-exempt option.

Benz: So, if after that calculation, the muni fund or bond is ahead of the taxable bond or fund, then you may be better off with muni?

Sjoblom: Right. And I should note, has a calculator that can help you with that decision and comparison, as well.

Benz: One thing I know a lot of investors struggle with is if they are doing that comparison among a taxable-bond fund and a municipal-bond fund, how do they find apples-to-apples comparisons? So, what's an appropriate taxable fund to compare with a potential municipal fund that you're looking at?

Sjoblom: I think the view on this has changed in the past few years. Before the financial crisis, munis were seen as a AAA type investment. So, on the taxable side, a comparable bond might be a U.S. government bond or Treasury. Since then we've really discovered that the municipal-bond market has its unique dynamics. It's got unique supply and demand dynamics, unique credit dynamics that really make it tough to have a perfect comparison in the taxable market.

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