Many expect lawmakersto let the 2001 tax cuts sunset after this year. Unfortunately, that means income tax rates are likely to be higher in 2011. The higher the tax rates, the greater the appeal of tax-exempt muni bonds. If advisors increase client muni holdings, a basic decision is how to hold them. "Advisors often turn to bond funds because they see barriers to using individual bonds," says Steve Huxley, chief investment strategist at Asset Dedication in Mill Valley, Calif. "These barriers include fear that they don't know enough about bonds and the misperception that buying bonds is harder than buying a bond fund."

Recent developments, though, have made it easier to knowledgeably select individual munis for clients. More information is readily available, while new services allow investors to track even lightly traded munis. Armed with this information, advisors can reduce the default risk of buying individual munis and develop investment strategies to reduce the reinvestment risk.

BEST BUYS

If buying and owning individual munis has become easier, the advantages of investing directly in bonds are more relevant. "Individual bonds bring out the best feature of their asset class-predictability," Huxley says. "Their interest payments and return of principal at the redemption date are known in advance. With bond funds, predictability is lost."

For buy-and-hold investors, individual bonds reduce or eliminate interest-rate risk; the time and amount of repayment is predetermined, assuming no default. Historically, muni default rates have been lower than corporate rates, Huxley says. A muni with an AA or BB rating has been less likely to default than an AA- or BB-rated corporate bond.

Individual munis may be cost- efficient, too. Morningstar puts the average expense ratio for muni bond funds at 1%. With the average muni fund yielding 3.8% now, that's a lot to pay, year after year. (Investors in individual munis pay a fee via an upfront markup, effectively reducing the net yield.)

Even with markups, individual munis may offer relatively high yields these days. As of mid-January, a 10-year Treasury yielded 3.8%, according to Bloomberg, which works out to less than 2.5%, after tax, for the 35% tax bracket. Top-rated munis yielded 3.25%, tax exempt.

EMBRACING EMMA

There are good reasons why some planners are reluctant to recommend individual munis to clients. Making mistakes can be costly. Muni bond defaults reached $7.6 billion in 2008, according to Income Securities Advisors.

Avoiding bonds that are likely to default hasn't been easy. The muni market has over one million issues from thousands of issuers. Many are rarely traded, so getting reliable information has been difficult. A new website called EMMA (www.emma.com) has finally made this data easy to find. EMMA stands for Electronic Municipal Market Access. "It's the biggest thing that's happened to muni bonds in 10 years, especially for individual investors," says Lynnette Hotchkiss, executive director of the Municipal Securities Rulemaking Board (MSRB).

The site is free, with no registration required. To look up details on a particular issue, enter the bond's name or CUSIP number. Hotchkiss says there is information on 1.3 million bonds from 50,000 issuers on EMMA.

EMMA data on each bond falls into three categories: the official statement; continuing disclosure/advance refunding; and trading activity. Trading activity info, which goes back to Jan. 31, 2005, can reveal pricing trends as well as recent yields. A New York State Environmental Facilities issue maturing in December of 2010, for example, traded three times in 2009. A customer buying in early 2008 got a yield to maturity of 2.5%, tax exempt; in late 2009, that bond yielded only 0.7% to a new investor. "If a bond is callable, the site will show the yield to the earliest call," Hotchkiss says.

Advisors can also read the initial offering document, annual financial filings and other materials the issuer has published relating to that particular bond. Hotchkiss says that information may be more critical now. "A few years ago, over half of all munis were issued with AAA ratings. That's not true any more."

Many muni bonds got top ratings because they were insured, but bond insurance might not provide much assurance now. "Instead of looking at enhancements, investors want to look at the issuer's financial strength," Hotchkiss explains. "Buyers are becoming more sophisticated when they seek information, and that information is available on EMMA." Each muni bond issuer must also post "material event notices," she says, like the need to tap the reserve fund or a change in trustees.

EMMA has an alert system that "advisors love," Hotchkiss says. Planners and investors can specify an unlimited number of muni bond issues that they'd like to follow. They'll receive an email alert every time a disclosure document is posted relating to that security.