“I’m proud to be paying taxes in the United States. The only thing is – I could be just as proud for half the money.”
No one likes to pay taxes, imagine an investment that allows you to avoid paying taxes on your returns, legally. Is there such a thing?
Yes, there is, and they are called municipal bonds.
In our continuing series on bonds, this week’s adventure is going to explore the world of municipal bonds.
Funny fact, but that quote above actually appeared on the home page of the IRS at one point! I kid you not, who says they have no sense of humor.
Taxes aside, these bonds can be a great source of income and fantastic investments in their own right. We will discuss in this post the formula to determine whether a tax-free muni would mean greater take-home than a taxable bond.
After all, that is what this is all about, finding the best investment for us all.
In this post, we will learn:
- What a municipal bond is.
- What kind of rates they pay.
- The different kinds of municipal bonds
- How to determine the best tax-free rate for us.
- How to Buy a Muni
What is a Municipal Bond?
According to our friends at Investopedia:
“A municipal bond is a debt security issued by a state, municipality, or county to finance its capital expenditures, including the construction of highways, bridges, or schools. They can be thought of as loans that investors make to local governments. Municipal bonds are exempt from federal taxes and most state and local taxes, making them especially attractive to people in high-income tax brackets.”
These bonds are also known by the moniker “muni,” which is what we will refer them as going forward.
According to SIFMA, the size of the muni bond market was $3.8 trillion as of 2018.
The best feature of the muni is the tax-free component. To illustrate this, say you invested in a 10-year bond for $10,000 that paid 4% interest. Every six months, this muni bond will pay you 4% for the life of the bond, and then at the end of the ten years, they would pay our back the original $10,000.
But, the best part is unlike other corporate bonds, you would pay zero federal taxes. Whereas the corporate bond, you would be subject to federal taxes, plus any state and local taxes.
The muni is always federal tax-free, and some have the bonus of state and local tax-free. If you buy a bond issued by the state you live in, say Illinois, then you pay no state or local taxes on that bond.
Let’s look under the hood of muni’s and see how they work.
How Do Municipal Bonds Work?
Municipal bonds come in several different types of flavors, two to be exact. They are general obligation and revenue bonds.
General obligation bonds are used to fund public projects that aren’t linked to a particular revenue stream, like taxes, for example. Whereas, revenue bonds are essentially financing for public projects with the potential to make a few bucks, think to build a tollway or a dam.
General obligation bonds: These bonds raise funds for public projects which improve the communities they serve, but do not make money. An example would be a city issuing a muni bond to build a park or improve a school system. The general obligation bonds will never make money, but they will improve the lives of the community and its citizens.
Like corporate bonds, the general obligation bonds are backed by the full faith and credit of the issuer, the city or state. The promise of repayment means that the city is on the hook for the bond and must move mountains to ensure that they pay the bond back.
This promise usually means that general obligation bonds will be considered a safer investment than revenue bonds. Historically general obligation bonds are generally considered a safer investment than their cousin, revenue bonds. When buying these bonds, it is wise, as with all bonds, to investigate the issuing city’s credit rating to make sure it is a strong investment.
Revenue bonds: Issuing bonds that create projects that can generate profits are revenue bonds. Where general obligation bonds are backed by the full faith and credit of the issuer, revenue bonds are backed by the revenue streams they create.
For example, a city may issue revenue bonds tied to the building of a toll-road. The money that would be collected in tolls could then be used as revenue, which would be able to be used to pay back its bondholders.
Revenue bonds are easy to create and get funding for, but they also have higher default rates than general obligation bonds, so they require more investigation and research into the issuer’s credit ratings before investing in revenue bonds.
Ok, now that we have an idea of how municipal bonds are constructed, let’s discuss one of the possible benefits that they might offer us.
Taxes, Taxes, Taxes
One of the primary attractions of municipal bonds is the tax element. So what exactly is the tax portion, and how does it work? Let’s take a look and find out.
On the basic level, all municipal bonds are free from federal taxes and, in some cases free from taxes on a state and local level as well. Because of the tax implications of municipal bonds, there is an added implication to do your due diligence regarding the tax effects. For example, if we buy municipal bonds from another state, our home state may tax the interest income from this bond.
Municipal bonds, because of their tax benefits, are a particular favorite of high-income earners.
One thing to keep in mind, while the interest income is tax-free, capital gains are a different story, like with a stock they are subject to federal and state taxes.
The capital gains are only going to be subject to the gains from the difference in selling price versus the purchase price, not the interest payments. The interest payments are still tax free; only the principal is to be considered in the capital gains equation.
Unfortunately, any capital losses are not to be considered in the tax equation regarding municipal bonds. The IRS does not allow capital losses and treats tax-free instruments differently.
They type of brokerage account we put our municipal bonds in does matter as well. The benefits of the municipal bond make them the perfect choice for a traditional brokerage account. You don’t want too many munis in your 401k or Roth IRA.
The main reason for this is these accounts already offer tax-deferred growth, or tax-free in the case of the Roth. We would be wasting the tax benefits of the muni by keeping these bonds in an already tax-advantaged account.
Ok, so now we have a better understanding of how taxes and municipal bonds work, let’s get an idea of how they affect our returns and choice of choosing a muni versus a corporate bond.
Or in other words, does the tax break give us a better return with a muni or with another choice of a bond.
How to Calculate A Municipal Bond Return?
When comparing two bonds to each other, the process is relatively simple: the bond with the higher yield wins. But with municipal bonds, that process is slightly more difficult because it is not simply which yield is higher. We also have to determine what our tax-equivalent yield would be after taxes, or in the case of the muni, no-tax.
Tax-equivalent yield is a term we are going to become familiar with in regards to munis. It refers to measuring the yield of a taxable bond versus the yield of a tax-exempt bond and determining what yield would make it equal.
Calculating the yield of munis compared to regular bonds allows for apples to apple comparisons. The comparison helps us determine which yield would be a better fit for our needs.
Typically the yields of a muni are lower than other bonds, the tax-exempt portion being the strong motivator to invest in a municipal bond. If that yield is less than a corporate bond, for example, then the incentive to invest in a muni is a moot point.
For example, let’s say we have a taxable bond that pays 4% interest, your real return is going to be less than 4% because we have to pay taxes on those interest payments.
So how do we calculate this tax-equivalent yield?
Tax-equivalent yield = interest rate / (1 – tax rate)
Let’s create an example to see how this can work. Say we are in the 25% tax bracket, and the municipal bond we are looking at has an interest rate of 3.1%. We want to know the real rate of return on a municipal bond, versus the return on a taxable bond.
Tax-equivalent yield = 0.031 / (1 – 0.25)
Tax-equivalent yield = 0.031 / 0.75
Tax-equivalent yield = 4.13%
The above results mean that we would have to find a taxable bond, CD, or savings account paying at least 4.13% to match the same return you would yield from your 3.1% municipal bond.
The above example assumes we are only discussing federal taxes; if the above muni were also state and local tax-exempt, the rate of return would be even higher.
Let’s take a look at another example, shall we?
To look up municipal bonds, one of the sites that I use to start my investigation is municipalbonds.com, this site is a great place to learn more about muni bonds and find ideas to investigate.
Based on a real quick scan for a muni, I came up with this bond:
San Francisco California City and Taxable Sanitary Fransico Redevelopment. CUSIP 79771PU86
The above bond has a coupon of 8.406%, with a maturity date of 8-1-2039, so it is a 20-year bond. The yield on the bond is currently 3.668% and is investable for a cool $1 million. A little out of my price range but great for our example purposes.
To find an equivalent taxable bond, we will use our above formula.
Tax-equivalent yield = interest rate / (1 – tax rate)
Let’s say we are in a higher tax bracket of 40% and based on the current yield of our muni at 3.668%. We are plugging in the numbers to the above formula.
Tax-equivalent yield = 0.03668 / (1 – .4)
Tax-equivalent yield = 0.03668 / 0.6
Tax-equivalent yield = 6.11%
To find a yield equivalent to our muni bond of 3.668%, we would need to find a taxable bond, CD, or savings account yielding 6.1%.
You can see as we move higher in the tax bracket, the lower yield we can accept with a muni bond, and there lies the strength of these bonds. Because to find a savings account, CD, or taxable bond that yields 6.1% in today’s rate environment would be quite the challenge, dare say impossible.
If our tax rate is in a lower bracket, it would be possible to find equivalent yields to match the muni’s tax benefit.
If running numbers is not your cup of tea, try this calculator to make your life easier.
As with any investment we consider, there are risks associated with municipal bonds. Muni bonds are considered safer than corporate bonds, for example. But they are open to multiple risks that we must be aware of, even though they might never manifest.
The first risk associated with munis is interest rate risk:
This risk is inherent with any bond that we would purchase, and munis are not exempt from this risk.
Interest rate risk would be, for example, say we buy a 10-year bond paying 2.5% interest, and several months later, we discover that the same issuer is now offering the same bond for 3.5%. All of a sudden, the value of our bond would drop, because the same muni is available for a better rate. If we continue to hold our bond, we run the risk of losing out on a higher potential return due to the lower interest rate.
Default risk: Although considered safer than corporate bonds, munis do run the risk of default, highlighted by the recent defaults of Detroit in 2013, and more recently, Puerto Rico.
What causes cities to default on their bonds? Numerous factors could lead to a city defaulting on its bonds. For example, if a project with a revenue source, like a toll, is poorly managed and winds up costing more than projected or is taking longer to complete than expected. Then the city falls behind financially and might struggle to make its payments.
In 2014 former Fed Reserve chairman Paul Volcker co-authored a study, “Final Report of the State Budget Crisis Task Force.” Although a boring title, the findings were a little scary, especially for muni bondholders.
The report found four threats to the muni bond market.
The list from thebalance.com:
- “Contributions to employee pension funds aren’t enough to cover future guaranteed payouts to retirees. Cities have three poor choices. They must either raise taxes, reduce spending on other services, or cut benefits.
- The largest expenditure for state budgets is Medicaid. These health costs are rising, which could cut into state revenue-sharing with cities.
- Cities and states are issuing bonds to cover current operating costs.
- They are selling off assets to pay operating expenses.”
As you can see from above, it indicates that cities are running out of funds and are not able to support updating infrastructure, schools, roads, etc.
Going forward, it will bear further investigation when considering investing in muni bonds.
How to Buy?
Buying munis are relatively simple to buy; they trade on the secondary markets like corporate bonds, which means you can buy them from your financial advisor, bank, or the city/state itself.
A fantastic resource for researching munis is the website EMMA, which stands for Electronic Municipal Market Access. The website provides bond type, yield, maturity, bond ratings. It also allows a deeper dive into topics such as credit quality, risk factors, and audited financial statements.
It is incredibly simple to use, you click on your home state and start browsing away. There are statistics available, the ability to compare bond prices, and a calendar of new issues. If you are serious about investing in municipal bonds, this is the website for you.
Because munis don’t trade publicly, the same rules apply as for corporate bonds, buyer beware. It is a must that you research the broker, and the prices you pay to ensure you aren’t paying too much.
Munis are rated just like corporate bonds, so the big three of bond ratings are relevant here, Moody’s, S&P, and Fitch. Munis carry the same types of ratings that corporate bonds carry, making the comparisons easier.
The same risks that apply with corporate bonds are relevant here too, any bond that falls below investment grade carries increased risk of default, and you should handle with caution.
Rates for munis will be slightly higher than yields for Treasuries, as they are a slightly higher risk than treasuries. As with corporate bonds, the higher rated bonds will carry lower yields than lower-rated bonds. But, with higher yields come higher risks, so keep that in mind when considering investing municipal bonds.
Municipal bonds are another tool we can use in our investing toolkit. The risk associated with munis is much less than corporate bonds, but the risks are something to be aware of when making our decisions.
Although they carry less risk than corporate bonds, they also carry less yield than corporates; munis can be a great asset to include in your portfolio.
As we discussed, the tax implications of municipal bonds is a great feature, and calculating your yield versus the yield of any other fixed-income assets is quite simple.
Another benefit of munis that we didn’t discuss, they allow us to invest in our communities and build a better place to live. Munis also allow us to build a secure stream of income with lower levels of risk.
Munis are not for everyone, so it is critical to investigate each bond and make sure they are a good fit for your portfolio.
As always, thank you for taking the time to read this post and I hope you found something useful to help you with your investing journey.
If I can be of any further assistance or if you have any questions, please don’t hesitate to reach out.