Municipal Bonds vs. Taxable Bonds and CDs

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Municipal Bonds vs. Taxable Bonds and CDs

If you answer a friend’s question, “Are tax-exempt municipal bonds a better investment than taxable bonds?” with a firm “yes” or “no,” you may be doing your buddy a favor. The proper response is determined by a variety of elements unique to each individual’s situation.

The most significant of them is the magnitude of your tax bill. If you are in the 35% tax bracket and reside in a state with relatively high income tax rates, municipal bonds (munis) are likely to be a better investment than taxable bonds. Alternatively, if your salary is in the 12% tax level, you should avoid municipal bonds.

Key Takeaways

  • Tax-exempt municipal bonds (munis) are often more appealing to people in higher tax categories.
  • To compare municipal bonds to taxable bonds, you must first calculate the muni’s tax-equivalent yield.
  • Municipal bonds have outperformed CDs while carrying less risk.

How to Compare Municipal and Taxable Bonds

While your tax rate might serve as a guideline when evaluating munis in general, you should look more thoroughly at unique investment options. You must specifically compare the muni’s return to that of a similar taxable bond by calculating its tax-equivalent yield. The tax-equivalent yield, also known as the “after-tax” return, considers your current tax rate to assess if an investment in a municipal bond is similar to a matching investment in a particular taxable bond.

Fortunately, there’s a formula for that. It is:

Tax EquivalentYield = Tax ExemptYield ( 1 MarginalTaxRate ) textTax – textEquivalent Yield = frac Tax on text – Exempt Yield text ((1 – textMarginal Tax Rate)) Tax−EquivalentYield= ​

Using this technique, suppose you’re considering a tax-free muni with a 6% return and your marginal tax rate is 35%. You would enter the following numbers:

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Tax Equivalent Yield = 6 ( 1. 3 5) \ frac6(1 -.35) textTax – textEquivalent Yield=frac6(1 -.35) Tax−EquivalentYield= In this situation, your tax-equivalent yield is 9.23%. This implies that if comparable taxable debt instruments provide yields of 7% to 8%, your municipal bond with a 6% yield provides a greater return (even though its nominal yield looks lower).

Assume you’re in the 12% tax bracket. 6.8% (6 [1-.12]) would be the tax-equivalent return. In this case, a municipal bond with a 6% yield would not be a superior investment than taxable bonds earning 7% or more.

Municipal bond after-tax yields often outperform taxable bond rates for anybody with a marginal tax rate of 24% or above.

Municipal Bonds vs Corporate Bonds

Naturally, return isn’t everything. Default risk must also be considered by investors. Municipal bonds have historically had low default rates. The Municipal Securities Rulemaking Board (MSRB) reports that the 10-year average cumulative default rate for investment-grade municipal bonds was.18% in 2016, compared to 1.74% for corporate bonds.

Municipal bonds are classified as either general obligation (GO) bonds or revenue bonds. Both are tax-free. Despite the fact that the latter is significantly more prevalent, the former is far safer. GO bonds rely on revenues (mainly property taxes) to pay bondholders interest and, ultimately, principal. Revenue bonds rely on the income produced by a project to repay investors, hence their performance is influenced by economic circumstances, making them riskier.

Municipal Bonds vs. CDs

Now that we’ve seen how munis compare to taxable bonds like corporate bonds, let’s examine how munis compare to certificates of deposit (CDs).Although CDs seem to be a superior alternative since they are FDIC-insured and so have no risk, they do have drawbacks. One disadvantage is that when interest rates fall, CDs struggle to keep up with inflation. Since a result, in a deflationary climate, holding on cash is a more practical alternative, as your dollars will go farther. Of course, if you’re stuck with a CD, you’re creating some interest while you wait, which is a good thing. Municipal bonds, on the other hand, have consistently outperformed CDs by a significant margin.

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$82.7 billion

According to MunicipalBonds.com, the amount invested in muni funds in 2019 reached a new high.

The Bottom Line

Your exposure to tax-exempt municipal bonds should be determined by your tax bracket, investing objectives, and geographic region. Locally issued munis will be triple tax-exempt if you reside in a high-income-tax state, meaning they will be free of not just federal taxes, but also state and city/county taxes. Municipal bonds, in an ideal world, would be part of a well-diversified portfolio that includes domestic and international stocks, real estate holdings, mutual funds and exchange-traded funds (ETFs), and even other debt instruments such as US government bonds, Treasury inflation-protected securities (TIPS), and corporate bonds.

What is a municipal bond?

Municipal bonds, often known as “muni bonds” or “munis,” are simply loans made to local governments by investors. These investments help pay for local necessities such as roadwork, bridge building, and school construction. Most federal, state, and local taxes are frequently excluded from municipal bonds.

How do I determine if I should invest in a municipal bond?

Investors interested in municipal bonds should assess the rate of return, risk concerns, and their tax bracket.

Are municipal bonds risky?

Municipal bonds, specifically general obligation (GO) bonds, are a low-risk investment. This is because GO bonds compensate investors with taxes. Municipal bonds may also be revenue bonds, which carry a greater risk. Municipal bonds support local initiatives, whereas revenue bonds repay investors with the money generated by these investments. If anything goes wrong with the project’s economic circumstances, investors may lose money.

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