Think Twice Before Buying Tax-Free Municipal Bonds

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Think Twice Before Buying Tax-Free Municipal Bonds

Municipal bonds, or “munis,” are popular among investors for two reasons. They are not subject to federal taxes and are low-risk investments.

While safe, income-producing bonds should be included in every well-diversified portfolio, there are certain disadvantages to buying munis. Individuals interested in acquiring muni bonds should evaluate various considerations before incorporating them into their financial plan.

Key Takeaways

  • The interest on muni bonds is tax-free at the federal level, but there may be state or municipal taxes, or both.
  • Be aware that if you receive Social Security, your bond interest will be included in the calculation of your taxable Social Security income. This might result in you owing more money.
  • Municipal bonds often pay lower interest rates than corporate bonds. You must assess which trade provides the highest actual return.
  • On the bright side, as compared to practically any other investment, highly-rated municipal bonds are often relatively safe. The default rate is negligible.
  • Interest rate risk exists, as it does with any bond. If you lock up your money for ten or twenty years and interest rates climb, you’ll be left with a bad performance.

Understanding Municipal Bonds

A municipal bond is a loan made to a state or local government or an organization controlled by it. A government or organization may issue a bond to cover ordinary costs or to support a particular public project, such as bridge building.

A muni, like any bond, is a debt investment. The investor basically loans money to a government or agency in exchange for a regular inflow of interest. The investor’s money is repaid at the conclusion of a defined time period.

Why Investors Buy Bonds

Bonds are purchased by investors in order to provide a consistent source of income (through interest payments) while protecting capital (since they will get their money back in the end.)

Many investors allocate a percentage of their entire holdings to bonds to counter the higher risks associated with practically any other sort of investment, particularly equities. This is the goal of diversification: Low-risk investments insulate higher-risk investments from possible losses. Bonds are not without risk. The issuer faces the danger of defaulting on its loans.

By reviewing the bond’s rating, investors may determine the risk level of a bond they are contemplating. Moody’s Investors Service, S&P Global, or Fitch Ratings assign ratings to all bonds sold in the United States. Bond ratings are based on an examination of the issuers’ creditworthiness.

How Municipal Bonds Differ

The federal tax-free status of municipal bonds is a major selling feature. That is, interest payments are not subject to federal taxation. Municipal bonds are not taxed in certain states, while they are in others. It is, predictably, complex. Because seven states have no income tax, bond interest is irrelevant. Other states do not tax in-state bonds but do tax out-of-state bonds under certain conditions.

There are many reasons to thoroughly examine municipal bonds before investing, and to compare them to other options for investing your money:

  • Municipal bonds that are tax-free are not always tax-free. As previously stated, the interest may be subject to state income taxes. If you receive Social Security, your muni bond interest will be added to your adjusted gross income, thereby raising the amount of your Social Security income that is taxed. Less often, the de minimus tax and the alternative minimum tax may have tax effects.
  • Unless you just dislike paying taxes, the goal of tax-free municipal bonds is to increase your total return on investment. Take cautious not to select a lower return on your money in order to reduce your tax burden.
  • Municipal bonds, like all other bonds, are subject to interest rate risk. The larger the risk, the longer the duration of the bond. You will miss out on a better yield if interest rates increase throughout the life of your bond.
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To compare the actual return on a muni bond with a corporate bond, use the tax-equivalent-yield calculation.

The calculation is as follows: Tax Equivalent Yield = Tax-Free Yield / (1 – Tax Rate).

That is the yield that a muni must have in addition to its federal tax-free status in order to match the yield of a corporate bond.

Comparing Real Returns of Muni Bonds vs. Corporate Bonds

Bonds used to pay local and state government projects such as buildings and roadways are free from federal taxation. Furthermore, consumers who buy bonds issued by their states or municipalities may not have to pay state or local taxes on the interest. As a result, certain municipal concerns are treble tax-free. These tax benefits are countered by reduced interest rates. Municipal bonds have lower coupon rates than equivalent rated corporate issuers with comparable maturities.

When contemplating munis, investors should use the tax-equivalent-yield calculation to compare the yields of taxable investment-grade and government bonds. The tax-equivalent yield (TEY) of a taxable bond must equal or surpass the tax-adjusted yield of a municipal bond. Yield Equivalent = Yield-Free Yield/ (1 – Tax Rate).In general, higher-income investors (with potentially greater tax bills) are more likely to gain from municipal bonds than those in lower tax categories.

Interest Rate Risk

The chances of default for governments issuing muni bonds in the United States are minimal. Bonds, on the other hand, are subject to interest rate risk by definition, which is essential for investors looking to sell their bonds on the secondary market.

When interest rates decline, a long-term investor’s primary investment may be jeopardized. A bondholder selling a 30-year issuance may get less in principle than the bond cost at the time of purchase.

Purchasing-Power Risk

Annual inflation in the United States has fluctuated from -0.7% (in 2015) to a forecasted high of 7% during the last decade (in 2021).Otherwise, it was 2.3% or below for the whole period. This indicates that a 20-year municipal bond yielding 2.5% to an investor in the 25% tax bracket, or a tax-equivalent yield of 3.3%, would provide inflation-beating returns every year until 2021, when it falls short of the rate of inflation.

The greatest potential disadvantage of long-term bond investment is the risk of losing purchasing power. You’ll receive your money back in the end, but it could be worth less than it was before. Investing primarily in low-yielding municipal bonds is a safe bet, but it may mean foregoing gains that outperform inflation and safeguard your spending power. A mix of municipal bonds and (relatively riskier) equities may help to mitigate this risk.

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Default Risk

Between 1970 and 2018, 0.16% of all municipal securities rated by Moody’s Investor Service defaulted on their payments to investors. That’s why muni bonds are considered a relatively safe investment.

The acid test of muni bond resiliency came with the COVID-19 pandemic as business activity ground to a halt and taxable receipts halted with it. Total defaults rose year-over-year to just 0.05% of the $3.9 trillion of municipal bonds outstanding.

Call Risk

A bond with a callable option exposes the investor to an additional risk. This indicates that the issuer has the option to terminate the issuance, pay down the principle, and cease making interest payments. The issuer wants that option in case interest rates fall significantly, allowing them to issue a new bond at a lower interest rate.

The majority of municipal bonds are callable. Their investors will get their money back, but they will need to find a new method to invest it. A new bond investment will yield them less.

For muni bond investors who earn a lot of money from tax-exempt sources, the alternative minimum tax might be a tax trap.

Municipal Bond Tax Traps

As previously stated, tax-free muni bonds are not always completely tax-free. Bonds are especially appealing to older adults looking for a consistent source of income for their retirement requirements.

As a result, the most prevalent hazard for muni bond investors is Social Security income. Although the bonds are federally tax-free, the income from muni bonds is included in the investor’s adjusted gross income. A greater adjusted gross income might increase the taxable percentage of a taxpayer’s Social Security income.

High-income persons may also be subject to the alternative minimum tax, which is directed directly at taxpayers who earn a significant portion of their income through tax-exempt sources.

How to Invest in Tax-Free Municipal Bond Funds

Bonds may be purchased and sold simply using an online brokerage account. They may also be obtained via a full-service brokerage or a bank.

Another alternative is to invest in a municipal bond exchange-traded fund (ETF) or mutual fund.

What Is the Average Rate of Return on a Tax-Free Municipal Bond?

Interest rates were increasing in late 2021, and municipal bond rates were following suit.

Ten-year AAA-rated municipal bonds returned 2.60% on July 10, 2022, compared to 2.70% the previous week. A 20-year AAA-rated bond returned 2.90%, down from 3.00% the previous week. A 30-year AAA-rated bond returned 3.05%, up from 3.15% the previous week.

Can You Lose Money on Municipal Bonds?

If the issuer fails, you may lose your investment in municipal bonds. That danger is negligible, given that municipal bond defaults totaled 0.05% of $3.9 trillion in outstanding debt in 2020, at which time local tax revenues were ravaged by the COVID-19 epidemic.

You may also lose money on muni bonds if you are compelled to sell them on the secondary market at an inopportune moment. The price you get will be decided by the total dollar amount of the remaining interest payments due, taking into account the current rates on new issuance.

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Which States and Cities Have the Best Municipal Bonds?

AAA is assigned to the finest muni bonds issued by any issuer. They are issued by state and municipal governments throughout the country, and one of the main rating agencies has rated them AAA. When a government has economic difficulties, its bond ratings deteriorate (but it also will pay a better interest rate in order to attract buyers).

Following its bankruptcy in 2013, the city of Detroit failed to make payments on three of its general obligation bonds. That implies it was responsible for three of the seven defaults on Moody’s Investors-rated municipal bonds that year. Since then, the city has managed to move from a “negative” outlook to a “stable” outlook from S&P Global for January 2021. It had a BB- rating on its outstanding debt.

One of the greatest municipal bonds is one that is rated AAA or near to it. One of the worst is a bond issued by a municipal government that is on the verge of bankruptcy. Investors who do not want to monitor the finances of the state and local governments in which they invest might invest in a bond mutual fund or ETF. It will be administered by someone who is paid to keep track of these things.

Are Municipal Bonds Safe?

A municipal bond, or any bond for that matter, is secure as long as its issuer does not go bankrupt. Fortunately, it is very improbable in the US bond market.

The bond investor’s best protection is to take care:

  • Examine the bond rating. Defaults are uncommon, although they do occur. A rating of AAA, AA, or A implies that the issuer is financially stable.
  • Compare the true return on the municipal bond to alternative investment choices. Saving money on taxes is always desirable, but not at the expense of a higher return for a similar risk elsewhere, such as in high-quality corporate bonds.

The Bottom Line

Municipal or corporate bonds are an excellent option for investors seeking a consistent source of income, especially throughout their retirement years. Highly rated bonds are, by definition, exceptionally safe investments when compared to practically any other choice, particularly equities.

Municipal bonds are exempt from federal taxes, as claimed. That doesn’t guarantee that a muni bond’s total return will be the greatest accessible alternative for you. You must still do due research to choose the finest municipal or corporate bonds for you, or the greatest combination of the two. Another option is to invest in a bond ETF or mutual fund and delegate the decision-making to someone else.

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