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Comparing MA Muni Funds to Online Savings Accounts

Background: I live and work in Massachusetts. I am in the 25% federal marginal tax bracket, and Massachusetts taxes wages, interest, dividend, and long-term capital gains at 5.3%, and short-term capital gains at 12%.

I have about $10,000 which is currently in a credit union money market account earning 1.65% APY interest. I see that I can do better with a savings account at an online bank such as ING Direct (3%) or HSBC Direct (3.5%). I have also been looking into municipal bond and money market mutual funds, and it looks like I have three choices between Vanguard and Fidelity for my state: VMATX (muni bond fund), FDMMX (muni bond fund), FDMXX (muni money market fund). I've been having some difficulty comparing these three funds with the online tools available at vanguard.com, fidelity.com, and finance.google.com. According to fincalc.com (love the site, saw it mentioned here), 3% taxable returns are equivalent to about 2.13% non-taxable returns in my tax situation.

I should not need the $10,000 or its proceeds for a few years (2+ at the earliest, 5+ more likely). It looks like the online savings accounts are pretty close to FDMXX in after-tax returns right now, and they are FDIC insured. The other two funds look like they might have a chance at slightly better returns, but they appear to be down for the year so far (bond funds baffle me; I would expect losses to come from defaults and defaults to be extremely rare for municipalities). Am I somehow misinterpreting the muni bond fund returns? Or should I just stay with savings accounts (or possibly CDs if I can find better rates) for now?

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Muni bond funds are down because bonds are like equities in that their value rises and falls with supply and demand. The ongoing problems in the general credit/financial markets have meant that a lot of investors have panicked and are putting their money into "safe" investments like cash or treasury bonds instead of muni or corporate bonds, so with less demand, muni bond prices are down, while treasury bonds are now overpriced. Also, because of the shakeups among bond insurers, insured muni bonds are taking an especially big hit. Muni bonds are not risk-free by any means; besides the values going up and down with the market, and there is also a risk of default. OTOH, most muni bonds are backed by authorities that can raise taxes to cover their debt obligations, just like federal government bonds, so it's questionable whether bond insurance even really buys you much for munis; the default rates for munis are historically very low. It would be more of a concern if you were investing in individual bonds, but with a bond fund, I pretty much figure that (a) the managers are pros who can do a better job than I can at evaluating the credit risks and (b) the credit risks are mitigated by holding a diversified portfolio of bonds.

Anyway, the good news about muni bond prices being down now is that this means you can buy them "on sale"; yields are high, and the bond values are more likely to go up than down when the credit crunch eases.

FWIW, I have most of my bond allocation in VMATX -- but this is money I have no immediate need for, and I have enough savings overall that it isn't going to kill me if I lose money on my bond investments. If you're going to lose sleep worrying about getting back every cent of your $10,000, you're better off sticking with a FDIC-insured savings account or CD.

-Sandra the cynic

-------------------------------------- Misc.invest.financial-plan is a moderated newsgroup where Moderators strive to keep the conversations on-topic for financial planning. Other posting guidelines include a request for brevity and another for trimming posts to which we respond. For all of the other tips and suggestions, see "FROM THE MODERATORS: Posting to misc.invest.financial-plan", a weekly post now on the Newsgroup.

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Sandra Loosemore

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