Investing 101: What Are Municipal Bonds?

Investing 101: What Are Municipal Bonds?

You’ve probably heard the commercials touting how municipal bonds supposedly "never lose a dime of principal,” and how the money you earn from them is exempt from federal, state and local income tax.

Sound too good to be true?

In the days of yore, municipal bonds were considered one of the “safest” investments because of the low risk of default. But in this age of major city bankruptcies (think Detroit or San Bernardino), investors may have reason to doubt the stability of municipalities around the country.

So we spoke to Marilyn Cohen, founder and chief of investment strategy at fixed income investing firm Envision Capital Management, and Brandie Farnam, Certified Financial Planner™ at LearnVest Planning Services, to examine exactly what municipal bonds are, whether they’re as useful as they’re purported to be, and whether they may be right for you.

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What Are Municipal Bonds?

Also known as muni bonds or munis, these bonds (loans that you grant to an entity in exchange for interest payments) are issued by a state, county or even a town or city. In exchange for loaning money to the local government, the earnings you make on municipal bond investments are exempt from federal taxes—and often from state and local taxes too.

Muni bonds are usually seen as “safer” investments because, although it is possible for a municipality to go bankrupt, the chances of default on the loan are relatively low. That said, due to the reduced volatility and the tax benefits, muni bonds generally yield smaller profits for investors than corporate or other taxable bonds.

Reason Number One to Consider Buying a Municipal Bond: Tax Savings

According to Cohen, investing in municipal bonds usually work best for people who are in a high tax bracket because the tax savings benefits of munis are higher for them. That said, you don’t necessarily have to be in the absolute highest tax bracket for munis to be helpful. “For example, let’s say I’m not in the highest bracket but the second-highest bracket, and I live in New York," Cohen explains. "New York takes so much through state income tax and city tax that my tax burden is already higher than it would be [for others in the same bracket who live elsewhere]."

“Munis are really for people in the highest income tax brackets because they can be triple-tax-free,” Farnam adds, referring to federal, state and local taxes. “But in order to enjoy that benefit, you have to buy bonds sold by your home state's government.” Translation: If you live in Ohio, buying Californian munis wouldn’t absolve you of state or local taxes.

There's yet another way that municipal bonds can come in handy: For people who are married with an adjusted gross income over $250,000, munis are one of the rare ways to circumvent the additional 3.8% tax that's associated with the Affordable Care Act and levied on high earners. In fact, notes Cohen, this is why many baby boomers are opting for munis—sometimes out of emotion more than pure financial sense. “If you feel taxed every which way and back," she says, "you might be O.K. with lesser gains in order to avoid being taxed on that extra amount.”

When comparing the tax-free yield of a muni to the taxable, higher yield of a regular bond, there’s a formula you can use to figure out which may be better for your own situation.

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First, calculate: [Interest on the muni bond] ÷ (1 – your tax rate).

For example, if you find a muni bond that would yield 4% interest, and you’re in the 25% tax bracket, the equation would be: 4.0 ÷ (1 – 0.25) or 5.33%. Now you can compare apples to apples. If a taxable bond of the same credit quality and maturity date yields more than 5.33%, consider going for it. Otherwise, the municipal bond is probably a better deal.

Other Reasons to Consider Buying a Municipal Bond

Another common driving force behind investing in a muni is to preserve capital, as opposed to growing it aggressively. Interest rates on munis are generally higher than a savings account or CD, but lower than typically perceived riskier investments, like stocks or other bonds.

“Muni bonds have a very low default rate,” Cohen says, adding that, given the current economy, interest rates are only likely to rise in the future. As a result, she says, “The longer the maturity of a bond or bond fund you buy, the more yield you’ll earn, but also the more risk there is…. So a lot of investors are going into shorter-term bonds or bond funds, sacrificing some yield to preserve capital.”

“In my opinion, bonds can be an important component for many investors' portfolios,” Farnam says, “but it’s important to remember that they’re also subject to volatility, especially if rates rise. They’re not ‘safe,’ like cash, but the risk of default typically is low.” Capital preservation may be particularly important for older investors. “When you’re in your thirties and forties, you can usually afford to take risks because you have time to make it up," Cohen says. "But if you're in your sixties or seventies, there’s no time to make it up.”

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Muni bonds can also help protect against market uncertainty. “When the stock market sells off and there’s another bear market, then muni bonds tend to be a more secure place to put your money, and chances are that their valuations may not be that volatile,” Cohen says.

One area when you probably shouldn’t invest in a municipal bond? Retirement accounts. Munis can be attractive because they’re tax-free, but if you’re using a tax-advantaged retirement account, you don’t have to worry about that. “I wouldn’t normally recommend putting munis into a retirement account,” Farnam says. Instead, you could invest in corporate or other bonds that pay higher yields, since the tax perks of munis usually aren’t very relevant for retirement investing.

Individual Municipal Bonds vs. Municipal Funds

Generally speaking, there are two ways to add municipal bonds to your portfolio: Buying individual munis and investing in a muni fund. Municipal bond funds are like other mutual funds in that they invest in an array of muni bonds, giving you exposure to many munis at once.

Cohen notes that it is possible to research and purchase your own municipal bonds using resources like the Municipal Securities Rulemaking Board. But to do so, you should do your homework and look at several factors, such as the revenues that a municipality makes from a new airport or construction project. You should also consider searching through annual financial statements to see whether the municipality’s government seems reasonably stable to help ensure that it won’t default on your loan.

The Pros and Cons of Individual Munis

One perk of investing in an individual loan is that “your investment will come due on its maturity date,” Cohen says, “whereas funds don’t have a maturity date.” In other words, unless the municipality defaults on its loans, you will get your money back. When you invest in a fund, you’re subject to the flux of the rising and falling bond market—which is influenced by interest rate changes and other economic factors—without a direct agreement from the debtor that you’ll get your money back.

Admittedly, buying an individual muni requires a fair bit of savvy and knowledge of bond terminology, from the alternative minimum tax to types of obligations and bond ratings. “But if you work with a registered investment adviser (RIA), that person can help you review and select muni bonds, and you avoid commissions,” Farnam says.

Another drawback? “If you have a very small amount of money, you probably can’t diversify,” Cohen says. Many bonds require a minimum investment as high as $5,000, and unless you have the cash to buy multiple munis, that’s a lot of money in a single investment.

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Pros and Cons of Muni Funds

If you opt for a muni fund, you'll likely want to invest in one that’s local to where you live. This way, you can nab those tax-free benefits on local and state taxes. If you invest in a fund that isn’t local, you’ll be absolved of federal taxes, but not the others.

Another reason for going local is that national muni funds may invest in munis from across the country, Cohen notes, and that would likely include some of the troubled areas that have hit the news as of late, like Puerto Rico, Chicago and Detroit.

“If you live in New York and buy a New York muni bond fund, that would give you exposure to a variety of different muni bonds, while also providing a tax benefit," Farnam says. “A fund would give you diversification with the kinds of bonds you’re exposed to.”

So how do you suss out a muni fund that may be right for you? “You should be able to find muni funds through a discount brokerage online,” Farnam says. Not every fund will be available through every platform, but you can search your brokerage’s mutual fund screener for municipal bonds from your state or region. And you should look for muni funds with low fees—high fees can eat into yields, which tend to be modest for municipal bonds.

LearnVest Planning Services is a registered investment adviser and subsidiary of LearnVest, Inc. that provides financial plans for its clients. Information shown is for illustrative purposes only and is not intended as investment, legal or tax planning advice. Please consult a financial adviser, attorney or tax specialist for advice specific to your financial situation. Unless specifically identified as such, the people interviewed in this piece are neither clients, employees nor affiliates of LearnVest Planning Services. LearnVest Planning Services and any third parties listed in this message are separate and unaffiliated and are not responsible for each other’s products, services or policies. Past performance is not indicative of future results.

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