[tachibana]

Warren Buffet's rules of investing: 1) Never lose money. 2) See rule #1.

I use municipal bonds to immunize my expenses (http://en.wikipedia.org/wiki/Immunization_%28finance%29). Municipal bonds (affectionately called "munis") are not subject to federal income tax because of a Supreme Court decision in the 1890s. Most states also exempt the interest on their own municipal bonds from their own income tax (of course, if you're in a state with no income tax like TX, then that's not really a problem). Furthermore, some states (like California) are constitutionally obligated to pay the interest on bonds before they allocate money to the the state's general funds.

My immunization strategy is simple: for every $10,000 I put into munis, I get anywhere between $40-50/month (average return on capital is in the 5-6% range these days) in passive income. Keep in mind that since this is not taxed, this translates to a pre-tax rate of return that's closer to 6.94%-8.33%, assuming a federal tax bracket of 28%; in reality it's a lot more because of FICA and state income taxes.

For long term growth and in tax-advantaged accounts, I use zero-coupon munis. Yes, being in a tax-advantaged account diminishes the allure of munis, but some of those bonds are now paying in the 7.5%-8.5% range.

[khafra]

Aren't municipal bonds paying better these days because of fear (justified or otherwise) that lots of them--especially in California--are going to start defaulting?

[tachibana]

Quick SEC disclaimer... I'm not an investment professional; I'm just sharing my personal experience.

It depends. Munis come in all flavors and sizes; the best ones IMHO are state-level "general obligation" (i.e. backed by state taxpayers) that do NOT fund revenue projects (this will make them taxable anyways). The second best ones, again in my IMHO, are classified as UTX ("Unlimited Taxation"), which gives the local government the power to raise local taxes in order to pay bonds. The ones I would be most worried about defaulting are the ones classified as LTX ("Limited Taxation") that fund revenue projects like local stadiums or toll roads; these bonds are paid back by the money collected by the underlying asset. Obviously, these would be the easiest to issue, as they do not require a referendum vote like UTX bonds, or state legislature approval like GO bonds.

Some states like California are constitutionally required to pay bondholders before any state-funded programs. Some states (like California) are also legally required to maintain a sinking fund, i.e. they can't make interest-only payments, but must also set aside money to pay back the principle owed to bondholders ever year. The "budget crisis" in California is because after paying back the 2 constitutionally mandated budget items, the state doesn't have enough money to keep the same level of spending as before.

In California, The interest on bond payments is an automatically budgeted line item every year; lawmakers can not change this without making changes to the state constitution.

[khafra]

Interesting, thanks. If I move to a state with income tax, or enter a tax bracket that warrants it, I'll definitely take a closer look at municipal bonds.

[riemannzeta]

Risk of default on these bonds has never been higher -- hence the yield. The market has plummeted in the past few months, but don't try to catch a falling knife.

[tachibana]

Quick SEC disclaimer... I'm not an investment professional; I'm just sharing my personal experience.

"Default" doesn't always mean that the principal won't get paid back. In almost all cases, it means that timely interest payments won't be made. Even in the most recent bond crisis in Puerto Rico, the "risk of default" was somewhat mitigated by the threat of shutting down the government offices (i.e. put the employees on unpaid furlough) just so the Puerto Rico could make their bond payments.

IMHO, it would be political suicide for a municipality or state to let bonds default. Here's an interesting article on this subject:

http://www.publicbonds.org/public_fin/default.htm

The default in the 1975 New York case was for revenue bonds. I don't know the exact details, but they sounded like LTX bonds.