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Bonds come in two flavors

Bonds are, and always have been, a crucial part of any long-term portfolio. The benefits of diversification cannot be overstated, and bonds offer important diversification benefits that go beyond mere safety of principal.

When constructing the bond portion of a portfolio, among the questions an investor needs to address is taxes. Bonds are available in two major flavors: taxable and tax-exempt.

Bonds issued by municipalities for public-purpose projects are tax-exempt. Those issued by California public agencies are exempt from both federal and state income taxes.

To make a fair conclusion about whether to buy muni bonds or conventional bonds, you would first need to make a decision about the credit quality and maturity you seek. You will need to compare apples to apples. You would not want to compare a high-grade muni bond against a junk corporate bond, or a 20-year muni against a 5-year treasury.

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Surprisingly, I see this latter situation all the time. I see retired investors in their 70s with 25-year muni bonds in the portfolio because they compared the yield against short-term treasuries.

Once you have your apples-to-apples comparison lined up, you do a bit of tax algebra. You need to know your top federal tax bracket.

Your next step is to obtain quotes on actual bonds. Naturally, you can also do the opposite and reduce the treasury yield to an after-tax figure. Either way, you want to know which bond gives you more money after taxes. If you are in the 33 percent bracket, the treasury bond gives you 3.33 percent after taxes. The muni bond is the clear winner here.

If you are comparing a muni bond to a corporate bond, you will need to account for California taxes. A 10-year high-grade corporate bond might yield 6 percent. To compare that to the muni bond, you need to deduct an additional 9.3 percent for California taxes. The muni bond is still the winner in this case. Also, be sure to only buy a California-specific fund.

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Most of the time, investors in the 28 percent or higher tax brackets will benefit from holding muni bonds rather than conventional taxable bonds.

This simple bit of analysis will help you to ensure that you are generating the most after-tax income available.