By: Ashley Wilson in 1535 November 22, 2010 9:53 am

Ashley Wilson

Investing in a world of uncertainty especially with regard to taxes can be tricky. For investors in a high tax bracket, consider adding tax-advantaged municipal bonds to a fixed-income portfolio.

The 10-year treasuries are yielding about 2.9 percent. Thats bad enough to cause a stomachache. Unfortunately, high quality corporate bonds arent much better. Ten-year, AA-rated corporate bonds are yielding between 2.5 and 4 percent to maturity. Ten-year, general obligation AA-rated Oregon municipal bonds are yielding about 3 percent.

Upon first glance, municipal bonds dont look especially attractive compared to some of their taxable counterparts. But in most cases, investors wont pay any state or federal taxes on interest income, so for Oregon residents in the top state and federal tax brackets, the equivalent yield is 5.14 percent. If the Bush tax cuts expire and the top federal bracket moves up to 39.6 percent in January 2011, then the tax equivalent yield may go up to about 5.4 percent more than double the treasury yield.

Despite the possibility of higher taxes, many investors are still frozen in low-yielding cash and treasuries. The current fiscal problems in the state and around the country are a cause for concern for many municipal investors. Even the Oracle of Omaha, Warren Buffett, has expressed concern about an acceleration of municipal defaults as municipalities face severe budget crises.

In the past, defaults increased after economic slowdowns, especially in areas that have experienced a rapid booms and busts. But if investors do their homework and follow a few principles, they should be able to avoid most of the default risk in this market.

First, look at the underlying bond rating. This gives an indication of the credit quality of the issuer. Many municipal bonds still carry insurance. Since the financial crisis, this insurance has essentially become a worthless guarantee in most cases. Investors must now scrutinize the underlying rating of the issuer. For example, an insured municipal bond might carry a AA+ credit rating, but the underlying rating of the issuer might be A- or even lower.

Second, understand where the highest risks are in the municipal market. Industrial revenue, multifamily housing, and non-hospital health-care bonds historically account for more than 50 percent of the defaults in the municipal market. General obligation bonds, by contrast, are backed by the full faith and credit of the issuer, which has the ability to raise taxes to service the municipal debt.

Essential service bonds, like sewer, water, and electric utility bonds, also have particularly low default rates thanks to their natural monopolies and consistent revenue streams, even during economic downturns. Escrowed-to-maturity municipal bonds are another option for cautious investors. The issuer of these bonds has already set aside the funds in an escrow account to pay off the bond.

I believe investors shouldnt wait for taxes to go up or the economy to improve before pursuing these opportunities. Also, note that income from particular municipal bond issues may or may not be subject to state and alternative minimum taxes. Remember to research thoroughly and consult a tax and financial adviser before investing.

Ashley Wilson, CRPC, is a financial adviser with the Wilson Financial Group of Stifel, Nicolaus & Co. Inc. member SIPC and NYSE, in Portland. Contact her at 503-499-6260 or wilsonam@stifel.com .