If the stock market makes you nervous with its volatile ups and downs, you may want to take a good look at a more conservative alternative to stocks—municipal bonds.

Mention tax-free municipals to some investors and you will be greeted with a big yawn. Munis, as they are called, are widely regarded as too conservative for aggressive investors looking for big capital gains. Others think of tax-free munis as beneficial only to wealthy investors in the top tax brackets. These days, both of those notions are wrong.

Contrary to popular opinion, you do not have to be in a top bracket to benefit from the tax advantages of municipal bonds, especially if you live in a state with high tax rates such as California, Connecticut, New York, Massachusetts or Pennsylvania. The interest on most municipals is exempt from federal income tax and, usually, local and state taxes, as well. That makes them a potentially good deal for a wide variety of investors.

And here is a surprise: According to a study by T. Rowe Price, a mutual fund company, munis returned an average of 6 percent a year during a recent five-year period. During this same period, stocks returned just over 4 percent a year after taking income taxes into account.

Regardless of your current tax bracket, municipals can help to strengthen your financial position. Of course, the higher your tax bracket, the more beneficial this favorable treatment becomes. However, even for middle-class investors in the 25 percent tax bracket, munis offer a competitive return coupled with far less volatility than equities.

Furthermore, investors who dedicated a significant portion of their portfolios to municipals in recent years have enjoyed a dramatic smoothing out of the scary roller coaster ride that equity investors have endured.

As a rule, bonds—including municipals—will rise in price as stocks fall, and vice-versa. Thus, when stocks take a plunge, bond prices often rise to cushion the shock.

Municipals are essentially the equivalent of treasury bonds, on a local rather than national basis. Keep in mind, however, that tax considerations are one of their major advantages. That is why it is not practical to include municipals in any tax-exempt retirement account, such as a 401(k) or an IRA. However, if you are building a retirement nest egg in a taxable portfolio, municipals can make a lot of sense.

Conversely, if you are saving for a child’s college education, a municipal bond portfolio makes it possible for that money to grow without incurring a tax obligation.

Understand the yields on tax-exempt municipals usually will be lower than on taxable corporate bonds. So, invest in tax-exempt securities only if your particular circumstances will allow you to save more in taxes than the additional amount you would earn from taxable investments.

Much as with stocks, building a solid portfolio of individually selected municipal bonds could prove to be a tough challenge for the typical small investor. That is why mutual funds make as much sense for bond investments as for stock investments. Almost every major mutual fund family offers a wide range of bond funds limited to individual states and a fixed range of maturities.

As with their equity counterparts, there are hundreds of different muni funds. One way to find the right funds is to log on to www.morningstar.com. You will find a wealth of information to help you choose. Look for funds that charge the lowest management fees and for those that invest solely in munis from your own state, thus giving them tax-free status for both federal and state.

In addition to their ease of diversification, bond funds have the advantage of liquidity. Some individual municipals are thinly traded, so an investor who decides to sell before the bond’s maturity could end up taking a loss. That is why, if you insist on buying individual municipals, you should plan to hold them until maturity.

Except for tax considerations, investments in taxable corporate bonds carry much the same advantages and risks as municipals. When you buy any type of bond, municipal or corporate, you are lending your money to the issuer in exchange for a fixed rate of interest. If you hold the bond to maturity, you will receive the face value on redemption.

One of the things that make municipals more attractive than corporates to some investors is that munis usually are rated higher by the major credit agencies, meaning default is less likely for municipals. Over the years, top-rated AAA munis have proven to be nearly as safe as U.S. Treasuries. However, investments in bonds, municipal or corporate, like any investments, are not entirely risk-free. The possibility of default, though rare, always is a possibility.

How much of your investment portfolio should be dedicated to municipal bonds depends on variables such as your tax bracket, your tolerance for risk and your age. Whatever your circumstances, tax-free municipal bonds offer you an opportunity to balance your portfolio to suit your individual needs.   EC

LYNOTT, a former management consultant and corporate executive, writes on business and financial topics for a variety of consumer and trade publications. Contact him at [email protected] or www.blynott.com.