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You can benefit from municipal bonds

You've made it through another tax season. If you got a refund, you might be pretty satisfied with how things turned out. But if you'd like to see a somewhat different outcome in 2008, you may want to review all areas of your tax return, including your investment-related taxes. As you may know, some investments are more tax-friendly than others — and municipal bonds might be some of the friendliest ones of all.

If you aren't that familiar with municipal bonds, here are the basics: Municipal bonds, or "munis", are issued in two main categories: general obligation bonds and revenue bonds. General obligation bonds finance the activities of state and local governments, while revenue bonds pay for specific projects, such as airports, hospitals and other civic institutions.

So, when you purchase a muni, you're supporting a project or service, possibly in your state or community. And you will be rewarded for your civic-mindedness — through tax breaks. Specifically, your interest payments will be free from federal taxes; if the municipality that issues the bond is in your state, your interest payments also may be exempt from state and local taxes.

Municipal bond interest is free from federal taxes, but some munis particularly airport and housing bonds —might be subject to the alternative minimum tax (AMT). If you think you may have to pay the AMT — and a lot more people are subject to this tax now than in years past  you might want to avoid these types of bonds. Conversely, if you know you won't be assessed the AMT even if you bought some AMT-subject munis, you might be especially interested in these bonds, because their yields are typically higher than the yields on regular municipal bonds.

In any case, municipal bonds offer some benefits beyond tax-free interest. For one thing, munis can help you diversify a portfolio heavily weighted with stocks. Municipal bonds may not be affected by many of the factors, such as poor corporate earnings reports, that cause volatility in the price of stocks. So, municipal bond prices generally do not move together with stock prices.

Furthermore, municipal bonds are among the most secure investments you can own. The default rate on munis, especially general obligation bonds, is typically quite low.

Which types of municipal bonds are right for you? Your choice depends, to a great extent, on your goals and investment personality. For example, longer-term munis — those bonds that mature in 10 years or more — will generally pay a higher interest rate than shorter-term bonds. Yet, prices of the longer-term offerings also may fluctuate more.

You may want to consider owning a variety of short-, intermediate- and long-term munis. This type of portfolio, known as a bond ladder, can help you in all types of interest-rate environments. When market rates are down, you'll benefit by owning long-term bonds, which generally pay higher rates than short-term bonds. But if market rates are up, you can use the proceeds of your maturing short-term bonds to reinvest in issues with higher rates.

Finally, when you're shopping for municipal bonds, look for quality — those bonds that are rated at least "A" or higher by the major rating agencies.

Municipal bonds occupy their own special niche in the investment world-- and it's a niche that you may want to explore further.

—Jimmy Stewart is an Edward Jones financial advisor in Urbana. He can be reached at 217-328-1719 or jimmy.stewart@edwardjones.com

Value investing has benefits over growth investing

Scott TapleyScott Tapley
CIBM Contributor

One of the constantly raging debates in the finance world is which investment approach is superior: growth or value?

Growth investors buy companies with above-average growth prospects, usually paying above-average price-to-earnings (P/E) multiples. Value investors look for companies selling at below-average P/Es, usually settling for companies with below-average growth prospects.

Proponents of growth stock investing often point to 10-baggersstocks that have risen 10-fold or more in value during spectacular run-upswhen making the case for their philosophy. The mantra of value investors is that slow and steady wins the race. Who's right? Both sides have their statistics, but we all know that it's been said if you torture the numbers long enough, you can get them to confess to anything.

I obviously won't end the debate with this short column, but I will share why I am biased toward the value camp.

The biggest reason I favor value investing is that almost every spectacular growth-stock run-up is followed by a nearly equally spectacular implosion. The reason why is simple: no company can continue to grow its earnings faster than the overall economy forever, so the above-average P/E a company enjoys during its rapid growth phase inevitably has to return to average at some point. That adjustment from a high P/E to an average P/E the technical term is reversion to the mean can be very painful for your portfolio.

Making the game even trickier is the fact that markets tend to over-reactprobably because markets are comprised of people who have a tendency to feel overly optimistic when things are going well and unjustly pessimistic when things are going poorly. So, when a rapidly expanding company's growth rate slows and its P/E compresses, often times the stock price is punished more than is justified.

There are countless real-life examplestake Home Depot, for instance. In 1999, it was trading at $69/share, a P/E of 60. Since then, the company's earnings nearly tripled, but the stock is now trading below $40, or a P/E of about 13. Why? Because growth slowed from the heady 30 percent rate of the 1990s, and 20 percent from 2000-2006, to an expectation of flat to slightly lower earnings in 2007 due to the well-publicized slowdown in U.S. real estate sales.

In 1999, at a P/E of 60x, Home Depot shares were priced as though earnings would grow 25 percent annually forever. But, now, at a P/E of 13, the shares are priced as though earnings may never grow again.

Let's look at a hypothetical comparison of two companies with the same earnings per share of $3 but divergent growth prospects. One company, HARE, is trading at a P/E of 30 because investors are excited about its prospects for growing earnings at a 20 percent annual clip. The other company, TRTL, is trading at a P/E of only 13, like Home Depot is currently trading, because its 8 percent expected long-term growth rate is merely average. HARE pays no dividends because management prefers to reinvest in its rapidly growing businesses; TRTL shareholders receive a 2.4 percent annual dividend.

If both companies deliver on their current growth expectations, but both end the five-year period with average expectations for future growth (and their P/Es revert to the long-term average of 15), the return differential is huge. Holders of HARE only realize a return of 4.5 percent, while TRTL holders enjoy a 13.5 percent return.

Of course, if HARE's P/E remained high due to continued high-growth expectations, shareholders could enjoy much higher returnsyou just have to try to sell before the growth slows and the P/E contracts. In reality, as you might expect, it's not that easy because the contraction in P/E usually occurs before the company's EPS growth actually declines.

In order to be a successful investor buying growth stocks, you really have to, in the words of country music singer Kenny Rogers, Know when to fold 'em. If you don't want to drive yourself crazy guessing whether the 25 percent pullback in your growth stock is just a normal correction that growth stocks periodically suffer during their rapid growth phases or the beginning of the growth rate (and P/E multiple) crashing down to earth, stick to buying value stocks that are justified by current earnings and dividends. You'll sleep better and enjoy superior returns over the long run.

 Scott Tapley, CFA, is a vice president/financial analyst with the Main Street Wealth Management Group. He can be reached at 217-351-6539 or scott.tapley@mainstreettrust.com.

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