Nine Myths About Municipal Bonds

Reality: Even if you're in the 25% federal tax bracket, municipal bonds could help you save on taxes.

In fact, municipal bonds could help you earn more on an after-tax basis than an investment in a Treasury or corporate bond. That's because, unlike other types of bonds, income from municipal bonds is exempt from income tax—federal and, in some cases, state and local, too.¹

Plese note, there is no guarantee that after-tax returns of municipal bonds will be greater than those of taxable investments.

Footnotes

For investors subject to the alternative minimum tax, all or a portion of the investment may be taxable, depending on the investment. Distributions of capital gains are generally taxable. To avoid the imposition of 28% backup withholding on all fund distributions and redemption proceeds, U.S. investors must be properly certified on Form W-9 and non-U.S. investors on Form W-8BEN.

Reality: With their impressive after-tax performance records, municipal bonds should also be attractive to more aggressive investors.

First, as illustrated in the chart below, municipal bonds have historically been the second best-performing asset class on an after-tax basis.² Second, diversification across asset classes (stocks, bonds and cash) is a time-honored way of managing portfolio volatility.³ Please remember, past performance does not guarantee future results. Treasury bonds, if held until maturity, offer a fixed rate of return and a fixed principal value; their interest payments and principal are guaranteed.

Footnotes

Source: © 2008 Morningstar (S&P 500 Composite Index); Lehman Brothers (long-term component of the Municipal Bond, U.S. Treasury and U.S. Credit Indexes). All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance does not guarantee future results. Indexes are unmanaged, and one cannot invest directly in an index. After-tax returns assume a 20% annual turnover rate transacted monthly. Investment income and capital gains are taxed at marginal historical federal tax rates consistent with those experienced by individuals earning $100,000 annually. Capital losses are carried forward to offset capital gains in future months. Distributions of capital gains are generally taxable. Effective tax rates for long-term taxable gains are as follows: 1987-April 1997 = 28%; May 1997-May 5, 2003 = 20%; May 6, 2003-June 2008 = 15%.

Please note, stocks and bonds are inherently different investments. Stocks represent part ownership, or equity, in a company. Bonds are IOUs, or debt, issued by a company, government or municipality in exchange for an investor's loan.

Reality: Historically, municipal bond default rates have been less than 1%.⁴

When severe budget deficits put pressure on state credit ratings, some investors may have shied away from state-issued municipal bonds. Unlike companies, however, state governments do not go out of business. Furthermore, most states are actually required to balance their budgets each year. Any default would taint a state's name in credit markets and would significantly increase the cost of future borrowing. That's why states will usually try to avoid defaults and close budget gaps with higher taxes and lower expenditures.

Footnotes

4.	Source: Moody's Investors Service, "The U.S. Municipal Bond Rating Scale: Mapping to the Global Rating Scale and Assigning Global Scale Ratings to Municipal Obligations," March 2007.

Reality: On a taxable equivalent basis, municipal bonds have been quite competitive.

On a pre-tax basis, it's true—muni bond yields generally tend to be lower than those of taxable bonds. But to make an apples-to-apples comparison between tax-free municipal and taxable bonds, investors must consider a municipal bond's taxable equivalent yield—which shows how much they would have to earn from a taxable bond to compensate for taxes, in order to equal or exceed the tax-free yield of a municipal bond.

Footnotes

5.	Source: Lehman Brothers (long-term component of the Municipal Bond, U.S. Treasury and U.S. Credit Indexes). Indexes are unmanaged, and one cannot invest directly in an index.

Reality: Over the 3-, 5- and 10-year periods ended June 30, 2008, municipal bonds were less volatile than comparable U.S. Treasury bonds.⁶

While Treasuries do offer greater credit safety, their safety attracts buyers from around the world. This global demand can make Treasury bond prices susceptible to global economic and political pressures. For investors who want or find they need to sell their Treasury bonds prior to maturity, this could be a concern. The municipal bond market, in contrast, is primarily driven by U.S. investors because of the tax savings benefits offered only to U.S. residents. Therefore, municipal bonds generally won't be subject to global pressures, as Treasury bonds can be.

Footnotes

Source: © 2008 Morningstar (long-term component of the Lehman Brothers Municipal Bond and U.S. Treasury Indexes). Indexes are unmanaged, and one cannot invest directly in an index. Treasury bonds, if held until maturity, offer a fixed rate of return and a fixed principal value; their interest payments and principal are guaranteed. Volatility is measured by the annualized standard deviation of monthly total returns. In general, the higher the standard deviation, the greater the risk.

Reality: With roughly 2 million municipal bonds outstanding, municipal bond investors face a staggering number of choices.

The municipal bond market currently includes approximately 50,000 issuers and roughly 2 million outstanding issues. That dwarfs the 4,200 or so publicly traded stocks on the major U.S. stock exchanges. To add to the confusion, municipal bond credit ratings must be considered relative to their respective sectors since different sectors are subject to different risks and economic pressures. For example, hospital bonds are typically partially secured by revenue sources such as Medicare and Medicaid. In contrast, general obligation bonds are secured by the issuer's power of taxation. Thus, an AA-rated hospital bond does not necessarily represent the same credit quality as an AA-rated general obligation bond.

Reality: Professional management and instant diversification make funds very attractive.

Although municipal bond funds do not offer a promised return of principal, as do individual bonds when held until maturity, funds offer investors several key advantages, including:

Reality: Interest rates are unpredictable—investors on the sidelines waiting for rates to rise may miss out on current income opportunities.

When interest rates rise, it's true that bond prices generally fall. Over time, however, higher interest rates can also lead to higher dividends. When interest rates rise, fund managers have the opportunity to invest in new, higher-yielding bonds. And as a fund's investment earnings increase, the fund is able to pay out higher dividends to shareholders over time. Moreover, as history has shown, even experts can't precisely predict when, in which direction or by how much long-term interest rates will change. Investors sitting on the sidelines over these past years have missed out on potential income.

Reality: Municipal bond fund managers can take very different approaches to investing.

For example, in an effort to boost their funds' yields, some managers pursue risky investment practices, such as using leverage, investing in derivatives or investing heavily in lower-quality sectors, all of which can increase share price volatility. Others stick to a "plain vanilla" approach, focusing on maximizing income without taking on undue risk. It's wise for investors to be aware of the differences so they can make sure their municipal bond fund has a management approach that matches their individual financial goals, time horizon and risk tolerance.

Municipal bonds are affected by interest rate movements. Municipal bond prices, and thus a tax-free income fund's share price, generally move in the opposite direction of interest rates. As the prices of bonds in a fund adjust to a rise in interest rates, the fund's share price may decline. These and other risks are detailed in a fund's prospectus.

If you have questions about municipal bond investing, we encourage you to contact your financial advisor, who is best suited to help you make investment decisions based on your individual investment goals and risk tolerance. If you don't have a financial advisor, let us help you find one.

Important Legal Information

For more information on Franklin tax-free income funds, please contact your financial advisor, or download a free prospectus. Investors should carefully consider a fund's investment goals, risks, charges and expenses before investing. A prospectus contains this and other information. Please carefully read the prospectus before you invest or send money.