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ETF Specialist

Not the Time for a Muni Run

Municipal bonds are still standing on firm fundamental ground.

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Municipal bonds have long been attractive for investors in high tax brackets, and investors should not dump them now. On an aftertax basis, muni bonds tend to offer solid income streams because their interest payments are exempt from federal taxes. But these benefits could diminish if tax rates come down, which looks like a real possibility in the wake of the U.S. presidential election. This risk led to 10 weeks of outflows from municipal-bond funds after the election. But it would be premature to abandon muni investments at this juncture. First, the implications of the new administration's proposed tax reforms are not as dire as investors might believe. Second, municipal bonds are some of the better-performing, lower-defaulting credit instruments. Finally, and most importantly, the state economies that back the credits of municipal bonds are on a solid fundamental footing.

Municipal bonds are obligations issued by state and local governments to finance their operations and fund public projects such as schools, hospitals, and roads. Broadly, there are two kinds of municipal bonds--general obligation and revenue--which are distinguished by the source of cash flows used for interest and principal payments. General-obligation bonds are backed by various tax sources such as property and income taxes. Revenue bonds draw cash flows from specific projects such as airports and bridges. Revenue bonds tend to offer slightly higher yields because they can't access the broader tax base, increasing their credit risks.

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