Municipal bonds were the underappreciated fixed-income products in the bond family. Unlike treasuries or corporate bonds, municipal bonds did not get a lot of attention from everyday investors. However, in recent years, their unique tax-exemption status has helped municipal bonds gain popularity, especially among investors with high income tax rates. In this article, we will teach you all you need to know to invest in municipal bonds and generate tax-free income in 2020.
What are municipal bonds?
Municipal bonds (muni bonds or munis) are debt securities issued by U.S. state and local governments. Governments issue munis to fund operations and infrastructure projects such as highways, water treatment facilities, schools, and more.
Like corporate bonds and treasuries, municipal bonds have fixed maturities and coupons. Investors receive semiannual coupon payments until maturity. What sets munis apart from other bond products is the unique tax benefits they offer investors.
Tax exemption
Interest incomes from corporate bonds and treasuries are taxed at your ordinary income rate, ranging from 10% to 37% in 2019. In contrast, income from municipal bonds is exempt from federal income taxes. This translates into 10% to 37% of tax savings on your investment income. For investors in the higher tax brackets, this saving is meaningful and can significantly increase your post-tax income.
Moreover, municipal bonds issued by the state you live in are also exempt from state taxes in general. For example, NYC residents can purchase NY municipal bonds with triple exemption from federal, state, and city taxes. Securities issued by U.S. territories such as Guam and Puerto Rico are also exempt from all taxes on the federal, state, and city level, regardless of your residence. This is the famous triple exemption.
Types of Municipal Bonds
Based on the source of payment funding, municipal bonds can be categorized into two types: general obligation bonds (GOs) and revenue bonds.
General obligation bonds are backed by the credit and taxing power of the issuing government. The repayment of GOs comes from the general funds of the municipalities. In addition, governments can levy additional taxes to pay for the coupons and principals on these bonds. This taxing power makes GOs very secure investment options.
Revenue bonds are backed by dedicated revenue streams from specific projects, instead of taxes. For example, a revenue bond used to finance a local highway is backed by the toll revenues only. The funding source for revenue bonds is more specific and limited.
Compared to revenue bonds, general obligation bonds are safer investments. GOs are backed a broader revenue source instead of revenues from specific projects. Their safety is further enhanced by the government’s ability to increase taxes to repay investors.
Investment horizon
Muni bonds have a wide range of maturities ranging from one year to thirty years. Municipal bonds with a longer maturity (ten years and more) often have a call feature that permits the issuers to repay the principal early should they choose to. These are the callable bonds.
Municipalities may exercise the call options on callable bonds when the current interest rate is lower. Lower interest rates allow the issuers to refinance their debts at cheaper rates. When the bonds are called, investors will receive their principal investment then, instead of at maturity. This means that investors will no longer get additional coupons and have to reinvest their savings in new bonds, often with lower yields. Thus, when making investment decisions, investors should pay attention to the call features and the possibility of a call.
Municipal bond yield
Because income from municipal bonds is exempt from federal income taxes, municipal bonds can attract investors with lower yields than corporate bonds and even treasuries. The annual yield on AAA municipal bonds has been historically lower than both US treasury and corporate bonds.
When comparing municipal bond yields, investors often refer to yield to worst (YTW). Yield to Worst is the lower of either yield to maturity (YTM) or yield to call (YTC).
Because YTW is the lower yield measure on a bond, it helps the investor understand the worst-case scenario return. For bonds without call features, yield to worst equals yield to maturity.
Taxable Munis
A few municipal bonds do not offer investors tax exemption. These bonds are taxable munis. Taxable munis have higher yields due to the lack of tax benefits. These taxable municipal bonds trade similarly like corporate bonds.
Comparing Munis and Taxable Bonds
Because income from munis is tax-exempt, we cannot directly compare muni yields to treasuries or corporate bonds; we need to compare like to like. To make a fair comparison, we can calculate the taxable equivalent yield of a muni bond.
The taxable equivalent yield shows you the yield that a taxable bond must offer to match the post-tax return of a municipal bond. It allows us to compare munis against taxable bonds. If the taxable equivalent yield of a municipal bond is higher than the corporate bond yield, the municipal bond offers a higher return and vice versa.
| Tax Rate | 10% | 12% | 22% | 24% | 32% | 35% | 37% |
|---|---|---|---|---|---|---|---|
| Municipal Bond | 2.28% | 2.33% | 2.63% | 2.70% | 3.01% | 3.15% | 3.25% |
| Corporate Bond | 3.12% | 3.12% | 3.12% | 3.12% | 3.12% | 3.12% | 3.12% |
Because the tax saving is based on your income tax bracket, the taxable equivalent yield of a municipal bond differs for each investor. The table below shows how the taxable equivalent yield of a muni bond varies with different income tax rates. For an investor at the 37% income tax bracket, the taxable equivalent yield is 3.25%, but it’s only 2.28% for investors at the 10% tax bracket.
Calculating taxable equivalent yield
Taxable equivalent yield varies for each investor. Using the formula below, you can calculate the taxable equivalent yield for any muni bond.
Taxable\ Euivalent\ Yield=\frac{Municipal\ bond\ yield}{1-Your\ federal\ tax\ rate}For example, an investor has an annual income of $75,000. This puts him in the 22% federal tax bracket. If an AA rated municipal bond offers a yield of 1.5%, the tax-equivalent yield would equal:
\frac{1.5\%}{(1-22\%)}=1.923\%1.923% is the taxable equivalent yield for this investor. If a corporate bond with the same credit rating offers a lower yield, this investor will be better off investing in this municipal bond. Otherwise, the corporate bond will be a better investment despite the income taxes.
Security
While municipal bonds carry more risk than US treasuries, they are safer than corporate bonds. Based on research by Moody’s, the average five-year default rate for municipal bonds since 2007 is merely 0.15%. The five-year default rate for global corporate bonds is 6.9%. Municipalities are generally more stable than corporates. Additionally, when a city or state gets into trouble, there is a chance of federal bailout.
Investors should take municipal bonds’ security into consideration when making investment strategies. Although municipal bonds might offer lower tax-equivalent yields than corporate bonds, the muni bond is more secure and less likely to default.
Liquidity
Some investors believe that munis are less liquid than corporate bonds and treasuries. While the municipal bond market is smaller than corporate bonds or treasuries, it is still a fairly liquid market. During my time as a municipal bond trader on Wall Street, I saw a very active muni market. Even high-yield bonds like Puerto Rico GOs were still actively traded.
Should I be investing in municipal bonds?
Munis can make a good addition to your investment portfolio given their security and tax exemption status. The higher your tax bracket is, the more tax savings munis can offer you. Muni investments should be tailored to your tax bracket and investment objective.
Know your tax bracket
Before investing in municipal bonds, you should first find out your tax bracket for the year based on the table below. With a precise federal tax rate, you can then calculate the taxable equivalent yield of any municipal bond you are interested in.
| 2019 Income Tax Bracket | Single Filer Income | Married Couple Income |
|---|---|---|
| 10% | $0 -$9,875 | $0 -$19,750 |
| 12% | $9,876 -$40,125 | $19,751 -$80,250 |
| 22% | $40,126 -$85,525 | $80,251 -$171,050 |
| 24% | $85,526 -$163,300 | $171,051 -$326,600 |
| 32% | $163,301 -$207,350 | $326,601 -$414,700 |
| 35% | $207,351 -$518,400 | $414,701 -$622,050 |
| 37% | > $518,401 | > $622,051 |
(Source: IRS, 2019)
Know your state’s rule for municipal bond income
While the federal tax status of municipal bonds is straightforward, each state has a different treatment on municipal bond income. In general, income from municipal bonds issued by the state you live in is exempt from state and local taxes. Income from bonds issued by other states might be taxed. However, some states such as Utah and Iowa will tax income from all municipal bonds. In contrast, bonds issued by US territories (Puerto Rico, Guam, and US Virgin Islands) are exempt from all federal, state, and local taxes.
Before making your investment, check with your accountant on how your home state taxes municipal bond income. This is especially useful if you have high state tax rates.
When not to invest in municipal bonds
While the benefits of investing in municipal bonds vary by your tax rate, an investor should never invest in municipal bonds in their IRA or 401K accounts. This is because retirement account such as IRA already offers investors tax-advantages that overlap with the tax exemption status of munis. Without the added tax benefits, investors are better off investing in other taxable securities with higher yields to maximize investment return.
How do I invest in municipal bonds?
Given munis’ great security and tax benefits, more and more investors are looking to add municipal bonds to their portfolios. There are two ways you can invest in municipal securities.
Option one: over the counter (OTC) purchase
Investors can buy municipal bonds directly. However, this method has a few drawbacks.
Unlike stocks, most fixed-income products don’t trade on centralized exchanges. When you purchase a municipal bond, you are buying it from another investor. Without a central exchange, investors need brokers to help facilitate transactions. Bond brokers charge a markup or a commission for each transaction. The markup and commission can be as high as three percent of the total investment.
Additionally, most municipal bonds are sold at $5,000 increments. This is a relatively high investment threshold for retail investors. The investment requirement also prevents people from building a diversified portfolio, because diversification requires a large amount of capital.
Option two: municipal bond funds
Investors can also invest in municipal bonds through funds that focus on munis. Municipal bond funds such as mutual funds and ETFs pool investor money and build a balanced muni portfolio. When an investor buys a share of a bond fund, they gain proportional ownership of the portfolio and all its incomes and gains minus the management fee.
A great advantage of investing in municipal bond funds is that you immediately own a share of a professionally managed muni portfolio.
This is convenient and diversification reduces risks. Each fund has its own investment objectives. For example, some funds focus on tax-exempt bonds issued by New York state and others might invest in high-grade GOs. You can always find one that fits your investment goal and tax strategy.
While mutual funds have minimum investment requirements, ETFs are less restrictive. You can buy as little as one share of an ETF. Even with one share, investors still enjoy the diversification of the fund. Muni ETFs reduce the investment threshold and give more investors opportunities to benefit from municipal bonds.
Risks
Municipal bonds share similar risk factors with other fixed-income products. Understanding the risk factors can help you minimize them and make informed investment decisions.
Interest rate risk
The interest rate has a large impact on bond prices. When a central bank raises the interest rate, bond prices fall. This is because in a high interest rate environment new bonds are issued with higher coupons than the existing bonds. Consequently, if bondholders want to sell their bonds, they have to reduce the price to attract buyers. Thus, the market value of the bond investment fluctuates with the interest rate.
Investors can measure the potential impact of interest rate on their portfolio by calculating the duration of their investments. You can learn more about this concept in this article.
Credit risk
Municipal bonds are debts. When you lend money to others, there is always a chance that they cannot pay you back. In the bond world, this inability to pay coupons or principal to bond investors is called a default.
Defaults can have different outcomes depending on the issuer’s financial strength. Sometime the issuer will get enough money to pay the bondholders eventually. Some issuers might offer a partial payment. Some cannot pay anything at all, and the investors will lose their money.
Analyzing an issuer’s credit strength is very difficult for regular investors. Fortunately, there are several trusted rating agencies that help investors evaluate an issuer’s financial strength.
Investors can use this rating as a guide in selecting their investment.
The three most trusted rating agencies are S&P, Fitch, and Moody’s. You can find their rating scale below.
Rating Agency Scale
| Moody's | S&P | Fitch | Category |
|---|---|---|---|
| Long-term Rating | Long-term Rating | Long-term Rating | |
| Aaa | AAA | AAA | Prime |
| Aa1 | AA+ | AA+ | High grade |
| Aa2 | AA | AA | |
| Aa3 | AA- | AA- | |
| A1 | A+ | A+ | Upper medium grade |
| A2 | A | A | |
| A3 | A- | A- | |
| Baa1 | BBB+ | BBB+ | Lower medium grade |
| Baa2 | BBB | BBB | |
| Baa3 | BBB- | BBB- | |
| Ba1 | BB+ | BB+ | Non-investment grade |
| Ba2 | BB | BB | speculative |
| Ba3 | BB- | BB- | |
| B1 | B+ | B+ | Highly speculative |
| B2 | B | B | |
| B3 | B- | B- | |
| Caa1 | CCC+ | CCC+ | Substantial risks |
| Caa2 | CCC | CCC | |
| Caa3 | CCC- | CCC- | |
| Ca | CC | CC | Extremely speculative |
| C | C | Default imminent | |
| C | RD | DDD | In default |
Inflation Risk
Inflation risk is the risk that the inflation growth can outpace your investment return, leaving you with less buying power. Bond investments are prone to inflation risks because of their fixed returns. For example, if your investment return is 3% but the inflation is 5%, your actual buying power decreases by 2% each year because of the high inflation.
Conclusion
Municipal bonds are a special class of fixed-income products. It has a large variety, consistent security, and unique tax benefits. At the same time, it shares the risk factors that affect all bond products such as interest rate risk and credit risk. Municipal bond investment benefits each investor differently, because the tax benefits depend on your income bracket. It is well worth the time to evaluate your tax status and investment portfolio to see if you can benefit from holding municipal bonds.
