Online Extra: Get the Most Muni for Your Money

Buy BBB or higher, use a no-load fund, and reinvest your dividends, advises fund manager Bob Pariseau -- especially for retirees

Investors who have enjoyed the bond market's healthy gains over the last three years should start taking some chips off the table, believes Bob Pariseau, assistant vice-president for fixed-income investments and manager of four municipal-bond funds for San Antonio-based USAA Investment Management. He says it's a good time to shift from bonds with longer maturities to intermediate-term bonds or from the intermediate to short-term issues as the economy recovers.

Pariseau runs the top-rated (5 stars from Morningstar) USAA Tax Exempt Long-Term Fund (USTEX ). For the last three years through June 30, the portfolio returned an average annual 8.82%, vs. 7.51% for all long-term municipal-bond funds, according to Standard & Poor's.

BusinessWeek Online's Karyn McCormack recently spoke with Pariseau about munis and how investors should allocate fixed-income assets -- a special concern for retirees, who are commonly advised to have the bulk of their portfolios in fixed-income assets, or for those who are thinking of reallocating their holdings as preparation for retirement. Edited excerpts from their conversation follow:

Q: With interest rates at 45-year lows -- and many retirement plans and insurance instruments pegged to those low interest rates -- how can investors boost their retirement income and return?

A:

That's a pretty wide-open question. The way I would approach it is to look at three different investors. The first has been roughly 40% stocks, defensively, and 60% fixed income, and has been since 1999. He or she has had a pretty good ride here. If they have a good cost basis, they probably can continue to ride the bull market in bonds.

If they wanted to take some of their chips off the table, it would be hard to argue with that. I don't see the bond market and yields running away from us right now. I still think that the economy is in a pretty precarious position and that growth, although it's positive and it will continue to improve, is going to be a lot slower than people would like.

For the people who have been overweighted in fixed income, I would say it's definitely time to take some chips off the table and maybe slowly reallocate into the stock market.

For the third set of investors who have had their money, figuratively speaking, hidden under the mattress and in money markets and isn't generating the income they need -- they should be extremely cautious in jumping into the bond market, be it either corporates, municipals, or Treasuries. They should very slowly put their toe in, between now and the first quarter of next year, to just slowly, methodically, in a very disciplined manner, start getting a full [recommended] allocation in fixed income.

Q: Are municipal bonds a good choice right now, even after the new tax-cut package?

A:

When the dust settles, I think the tax cut isn't going to be as important, and particularly for those people that are in states with higher taxes because your state taxes are deductible on your federal [return].

Municipals are the only security that I can think of that are quoted in aftertax yields. When you then adjust them using tax-equivalent yields, they look very attractive. For instance, the National Long-Term Fund that I manage has had an average annual dividend of 6% for the last 10 years. For someone in the 28% or now the 35% tax bracket, that tax-equivalent yield is somewhere between 8% and 9%, just from the income.

If you ask someone now after the stock market bubble burst and tell them how would you have liked to earn 8% to 9% tax-equivalent for the last 10 years each year, I think munis are going to look extremely attractive to them.

Q: Can you give an example of how the return is higher on an aftertax basis?

A:

Let's use again the National Long-Term Fund that I manage. For the last 12 months, it has distributed 4.7% in dividend, tax-free -- and none of it is subject to the federal alternative minimum tax (AMT) for individuals. The AMT is something that's getting, of course, more and more press. All of our funds are managed to not distribute any AMT, and that makes it different than a lot of other tax-free funds. If you're in the 35% tax bracket, that's a 7.23% tax-equivalent yield for my fund.

Q: How do you decide how much to invest in munis?

A:

The yield curve in municipals is typically positive, which means that as you go from 1 to 5 years to 10 to 15 to 20, the yields keep going up. If I'm going to decide my asset allocation and decide that 60% should go into fixed income, I need the other 40% in stocks for growth. Of that 60%, I'm going to put 10% in very-short, 20% in intermediate, and 30% in the long-term, 20-year-type maturities.

And so the longer you go, the more income you're going to receive. And in the long run, that's where the vast majority of your total return will come from.

Q: How can investors find and choose municipal bonds?

A:

First, buy only high-grade (AA, AAA, or insured) securities. Retail investors leave a lot of money and performance on the table by avoiding BBB- and A-rated bonds, but unless you can do your own credit research, I'd strongly recommend staying away from them.

If you don't know what the spread between bid and ask should be, buy a no-load bond fund. The advantage of a no-load muni fund is that they more than offset their management fee with better trade execution and holding well-researched bonds rated BBB or higher. Professional managers have a knack of ferreting out bonds that end up being refunded with U.S. government bonds -- upgraded and refinanced, so to speak. And you should only consider a no-load muni fund -- front-end loads eat up your income and total return.

The absolute best way that an individual can find a good value in the municipal market is to buy new issues because directly from a broker. That way they know they're getting the same price as everyone else, institutions and retail alike. So a really good way to maximize returns would be to buy on a primary, and then hold it to maturity. And that way they don't have to worry about pricing and calling five brokers to figure out what the bond is worth.

Reinvestment of your coupon payments [interest received] is very important, along with diversification and liquidity. If you're unable to reinvest your interest payments at close to the purchase yield, in the end you won't receive the full purchase yield (yield to maturity, or yield to call). It's simply the mathematics of bond investing.

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