Municipal bond and municipal bond mutual funds: Know the difference?

Municipal bonds are tax-exempt debt obligations issued by cities, counties, states and other governmental entities to finance the creation of projects that are considered beneficial to the public good: housing, schools, highways, hospitals, sewer systems and other essential infrastructure. Carson City, Carson Tahoe Regional Medical Center and, the State of Nevada have all been issuers of municipal bonds. Interest income from municipal bonds is generally exempt from federal income tax, and if you purchase a bond issued in your state of residence, you generally don't have to pay state income tax (a few states such as Nevada have no state income taxes). Some communities may impose local income taxes but may waive taxes on certain local, municipal bonds.

There are no local income taxes imposed anywhere in the state of Nevada. There are two main categories of traditional municipal bonds, general obligation bonds and revenue bonds. GO bonds are backed by the full faith and credit of the issuer, which extends to the municipality's full taxing power. Revenue bonds are backed by the revenue streams of the funded project, for example, toll roads and bridges.

For both GO and revenue bonds, the issuer promises to repay the principal in full at the bond's maturity, in addition to paying semiannual interest income. The stream of income is fixed and will never change with the life of the bond. Municipal bonds are typically available in denominations and increments of $5,000. The majority of municipal bonds are rated by Moody's Investors Service, Standard & Poor's and Fitch Ratings - the nation's three leading credit rating agencies - giving investors the ability to decide which level of credit quality they are comfortable with in relation to their investment objectives.

A mutual fund is an investment company that pools money from many investors and invests in stocks, bonds, short-term money market instruments or other securities. There are two types of mutual fund structures: open-end and closed-end. This article focuses on open-end funds, which are sold by prospectus, are actively managed by a fund manager and typically have a $1,000 investment minimum. Open-end funds are bought and sold on the basis of their net asset value, which is the net assets of the fund divided by the total number of outstanding shares.

Each share represents a proportional ownership interest in the portfolio's pool of securities; the dollar amount of shares in the portfolio is not fixed and the fund buys or sells shares as investors purchase or redeem units. There are several types of municipal bond funds with various maturities and attributes, including national tax-exempt, state tax-exempt, insured tax-exempt and high yield tax-exempt. Municipal bond funds are professionally managed and most pay a variable monthly dividend, which you may reinvest in the fund or take as a distribution (income).

This is a brief summary as it is impossible to discuss all the details of the two methods of investing in municipal bonds in this abreviated article. Your investment goals are the prime consideration when deciding between municipal bonds or municipal bond mutual funds. Individual bonds may be appropriate for you if you are comfortable making investment decisions, are averse to paying asset management fees and have a sufficient dollar amount to construct a portfolio that is diversified by geography, maturity and sector.

On the other hand, mutual funds may be a better fit if you have a relatively small dollar amount to invest, prefer professional asset management and don't have a pressing need for income, allowing you to take advantage of a fund's dividend reinvestment feature. Whatever your preference, your financial advisor can assist you in structuring a portfolio that is best suited to your investment goals. For more information, call me at 689-8704 or William.a.creekbaum@mssb.com.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of Morgan Stanley Smith Barney LLC. He can be reached at William.a.creekbaum@mssb.com or 689-8704. Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Smith Barney Financial Advisors do not provide tax or legal advice.