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Bonds May Attract Investors In 2006

by Carla Johnson, Investors

28 December 2005

If you have a jaundiced view of prospects for the equity markets in 2006, and you're thinking about bonds as a safe haven, you might want to consider mortgage-backed bonds or 'munis' (tax-exempt municipal bonds), say analysts in the US.

Morningstar reports a measly 2% return on mutual funds specializing in mortgage-backed bonds in 2005; but that's because the booming housing market led to an explosion in mortgage debt, and a matching explosion in the volume of the corresponding funds. But there was insufficient investor demand for these funds, driving down prices and overall yields.

The contrarian argument for 2006 is that a tightening housing market will reduce demand for mortgages and the volume of bonds and bond funds, so that bond prices and fund returns may increase. The 5-year average return on mortgage bond funds is 4.33%, according to Morningstar.

The mortgage bond market is very complex, however, and investors must take care, looking particularly at expense ratios and the types of mortgage covered by the funds. Mortgage defaults, however, probably aren't a worry, since most mortgages are guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae, all with explicit or implied government backing.

For investors paying high marginal rates of income tax, munis are also worth considering. Municipal securities are interest-paying debt securities issued by state and municipal governments. The tax-exempt status of munis relieves buyers from paying federal and - sometimes - state tax on the interest income, and allows municipal issuers to borrow at favorable rates.

Since munis typically carry lower coupons than other types of government bond, to reflect the tax advantage, it's necessary to calculate the return you'll get quite carefully, taking into account your federal and state tax position.

For example, someone with a marginal tax rate of 25% who buys a muni with a 5% yield, will receive a yield equivalent to a taxable 6.7%. If the muni also gives exemption from state income taxes (meaning, usually, if you live in the issuing state) the equivalent yield rises to 7.4% if the state tax is 10%.

Munis can be bought directly, but more usually they are bought through tax-exempt money market funds. As usual, be careful, and check expense ratios and other terms.

NB: This article does not constitute a recommendation or invitation to buy the investments discussed. Investors should use great care and obtain independent professional advice before making investments.

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