How Can Municipal Bonds Save You Money?
Munis are all about the tax benefit this type of investment can provide.
Municipal bonds, commonly known as Munis, are debt securities issued by various local governments like cities, counties, states, and other governmental entities to fund various projects and infrastructure goals as well as provide working capital for day-to-day operations in the case of uneven cash flows. Things such as building schools, hospitals, power plants, roads, bridges, airports, and other capital investments that have public use and benefits. The purpose behind Munis is typically related to community development and improvement.
There are 2 types of Municipal Bond Issues
General obligation bonds are backed by the issuing municipality’s “full faith and credit” including the power to levy tax. They are typically used for projects that improve and better local communities but don’t have any specific revenue source or collateral attached to them. This type of bond issue makes up about a quarter of the municipal bond market. On average, general obligation bonds have been rated higher than revenue issues.
Revenue bonds are bond issues that are backed up by a specific tax source or revenue generating project of the municipality – think toll road, water and sewer systems, special tax source etc. Revenue bonds make up about three-quarters of the muni market. Revenue bonds can offer higher yields but may also carry more risk.
While both general obligation and revenue bonds have a history of few defaults, it’s important to take time to do the research before investing.
Investors look to Municipal Bonds for a variety of reasons however none larger than the tax benefits that come along with them.
Tax-Free Income
One of the biggest draws to the Muni market for investors is the potential for tax-free income. Muni interest payments are generally exempt from federal income tax and may also be exempt on the state and local tax level if you are a resident of the state where the bond is issued.
The effect is a higher calculated rate of return over the bonds stated interest rate due to the tax-free nature of the interest income. The most common method for comparison of this impact is the Tax Equivalent Yield – this simple formula tells us what a taxable bond would need to yield to match a tax-free Muni issue.
Let’s say you are interested in buying a Municipal bond paying 5% annual interest.
Your Tax Equivalent Yield based on tax brackets would be:
22% tax rate = 6.40%
24% tax rate = 6.58%
32% tax rate = 7.35%
35% tax rate = 7.69%
37% tax rate = 7.94%
The example illustrates the higher the tax rate, the more valuable tax-free interest is to you.
** It’s important to note this benefit is specific to TAXABLE investment accounts – the benefits of tax-free income are negated by owning Munis within a retirement account.
This also works in the state or local governments favor as they can issue debt with a lower interest rate than corporations and attract investors.
Tax-free income is attractive but that’s not all there is to like about Munis.
Regular & Tax-Free Income Stream
Muni interest can play an important role in retirement income planning with regular and tax-free interest payments.
Relative safety and security
While it’s important to remember Munis aren’t risk free, default rates tend to be quite low due to the nature of these bonds and the backing of the state and local governments that issue them. They often carry investment grade ratings.
Diversification and Balance
Adding Munis to a portfolio may help to balance risk and potentially reduce overall portfolio volatility.
Community Development & Social Investing
By investing in state and local governments you may also be contributing to the stability and development in your local communities – potentially furthering growth and well-being.
Muni’s also often align with socially responsible investing – with projects related to the environment, renewables, clean infrastructure, and sustainable development.
Risks
While Munis come with benefits, it’s important to remember they also carry risk. Including credit risk, interest rate risk, market risk, call risk, legislative and regulatory risk to name a few.
How to invest in Municipal Bonds?
Munis are available to purchase as individual bonds or through a diversified investment vehicles such as mutual funds and exchange traded funds.
What investors might consider Munis?
Investors with taxable money, taxpayers in high income tax brackets, and people looking for conservative positioning within their investment portfolio.
Questions? I’m here to help and would love to hear from you.
-Justin
*The content is developed from sources believed to be providing accurate information. This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
