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The Short Answer

Do Municipal Bonds Have a Place in My Portfolio?

Consider the tax implications before adding a muni investment to your portfolio.

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Question: I know that municipal bonds offer great tax breaks for investors, but I'm not sure they make sense for my portfolio because I'm not in the highest tax bracket. Am I better off investing in municipal bonds or traditional bond funds? How would I know?

Answer: Late 2010 and the beginning of 2011 were marked by some scary (and exaggerated) headlines on the state of municipalities' finances, casting a shadow on municipal bonds, which had historically been a lower-risk part of the investment arena. In fact, by the end of August, investors had pulled nearly $22 billion from municipal-bond funds for the year to date.

But as much as investors should stay attuned to potential risks of this or any asset class, they shouldn't dismiss munis out of hand. For one, large-scale muni defaults are unlikely, and Morningstar director of fund research Russel Kinnel noted in this article that muni defaults have actually been dropping--not rising. All in all, the muni market has a long way to go before it lives up to all the dire predictions. And for income-oriented, tax-conscious investors, municipal bonds might still serve a worthy role--even for people whose taxable income doesn't land them in the highest tax bracket.

Esther Pak does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.