Investing in Your City: Understanding the Basics of Municipal Bonds
Should I Consider Tax-Free Municipal Bonds?
As we think about earning interest on our money, tax-free income certainly sounds nice. Fortunately, there are more ways to today to access tax-free income from municipals than ever before, but there are some things to know, and some math to calculate.
What are municipal bonds?
So, let’s start with what municipal bonds, or munis, are.
Simplified, Municipal bonds are a way for cities to get money for things like schools and roads. People can lend money to the municipality – which would be a City or a project – by buying these bonds, and then the city pays them back with interest. It’s notable that the interest is Federally tax-free, and if you buy a bond from your resident state, it’s also state tax-free.
- There are two main kinds of municipal bonds. The first is called a General Obligation bond, and used to fund projects that serve the public community but don’t necessarily generate revenue. Examples include schools, parks, and bridges. General obligation bonds are one of the safest types of bonds because they’re backed by the full faith and credit of the municipality. Because the municipality has taxing power, it can raise rates or levy new taxes in order to pay bondholders.
- The second is Revenue bonds – As the name suggests, revenue bonds are issued to finance revenue-generating projects. Examples include toll roads, utilities and concert halls. The revenue generated by the project is then used to pay back investors. Because revenue bonds depend on future cash flows from projects that aren’t yet complete, they’re riskier than general obligation bonds. It’s important to fully understand an issuer’s credit rating and past default rates before investing in a revenue bond.
So what are the Benefits of municipal bonds?
There are several benefits associated with investing in municipal bonds.
- Low default rates – Historically, The default rate of municipal bonds is significantly lower than that of corporate bonds. In fact, the five-year all-rated cumulative default rate (CDR) of municipal bonds from 1970 to 2020 was 0.08%, compared to a five-year CDR of 6.89% for global corporate bonds over the same time period.1
- Tax-free interest – The largest benefit of putting your money into municipal bonds instead of corporate bonds is that you don’t have to pay taxes on the money you earn from them. Corporate bonds might give you more interest to start with, but you end up with less because you have to pay federal taxes, and state taxes as well. Municipal bonds, on the other hand, are usually not Federally taxed, and if you own a bond from your state, won’t be state taxed either.
- So, Predictable, tax-free income in retirement – Municipal bonds typically pay interest twice per year, which can help enhance a family’s tax-free income stream.
But to really figure out whether municipals or taxable bonds are better for you, you need to calculate the tax-equivalent yield, which tells you how much you would need to earn from a taxable bond to equal the tax-free earnings from a municipal bond.
So, How do you calculate Tax-Equivalent Yield?
The first step is to know what tax bracket you are in. Municipals will start to look much more compelling when you are in the 32% tax bracket and above, which means north of a $400,000 income.
So let’s say you have an income north of $400,000 and are considering a municipal bond investment.
Let’s say the current yield of the municipal offering was 4.5%, and the yield of a comparable corporate bond offering was 5 ¼ %.
If you were in a 32% tax bracket, you’d take the yield of the municipal bond at 4.5% and divide it by (1-.32, or 32%).
So 4.5/(1-.32) = a 6.61% tax equivalent yield.
If we compare that to the corporate bond offering of 5.25%, a 6.6% tax equivalent yield is a much better.
Now let’s say we’re in the 22% Federal tax bracket with the same comparison. The math would be
4.5/(1-.22) = 5.76% tax-equivalent yield – so still better than the corporate bond, and worthy of further investigation.
Who benefits most from an investment in municipal bonds?
Investors who stand to benefit most from municipal bonds include those with high incomes living in states with high state and local income taxes. But, it’s worth doing the math, making sure you know any risks with what you are considering.
As with all investments, municipal bonds carry their own set of risks and drawbacks.
If you find yourself trying to determine if an investment in municipal bonds makes sense for your particular financial situation, reach out to our team at Professional Planning & Wealth for a conversation on how we could help create a plan for you.
This commentary is provided for general information purposes only, should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.
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