The promise of tax-free income, combined with a safety level that’s just below Treasury bonds, make municipal bonds a favorite of young and mature investors alike. Yet investing in “muni’s” is still as much of an art form as picking the right stocks.
Knowing when to use municipal bonds in your portfolio, as well as what kind to use, will help maximize the overall growth of your net worth. Central to your analysis will be an ongoing awareness of your “marginal tax bracket” at both a Federal and a State level. If you don’t know what this percentage is, a simple call to your tax preparer will likely answer the question.
-When To Use Municipal Bonds-
Municipal bonds are ideal for someone who wants the diversification of bonds, and also has a sizable portion of their assets outside of tax-favored accounts such as IRA’s or 401k’s. This situation is ideal, because the interest earned on municipal bonds is generally tax-free on a Federal and possibly state level.
To make a final determination if municipal bonds should be used, it’s necessary to compare the “tax-equivalent yield” on the municipal bonds, to other taxable bonds such as government or corporate bonds. While the formula is fairly simple, the internet abounds with calculators that do the work for you. Be sure to check out the links at the bottom for a couple of examples.
-When Not To Use Municipal Bonds-
With the exception of “AMT” or “taxable muni’s”, municipal bonds should never be purchased in a tax-sheltered account. Quite simply, you have no need to take the lower tax-free yield of a municipal bond, when the account itself already defers or avoids taxation. In that situation, an investor should take as high of a yield on a taxable bond as their risk profile can tolerate.
You should also minimize the use of municipal bonds (and for that fact, most bonds) if you are looking for double-digit returns out of your investment portfolio. While bonds bring a lot of stability to a portfolio during turbulent times, it’s at a cost. The historical rate of return of bonds hovers between 5 7%, while the U.S. stock market is just above 10%.
-How To Invest in Municipal Bonds-
Just because you’ve decided municipal bonds should be part of your portfolio, doesn’t mean your work as an investor is done. There are dozen of varieties of municipal bonds, which provide for some unique planning opportunities and considerations.
1. Individual Municipal Bonds versus Municipal Bond Mutual Funds
Just because you’re investing in municipal bonds, doesn’t mean you have to pick out the bonds yourself. Just like there are mutual funds comprised of certain sectors of stocks, there are also mutual funds comprised of municipal bonds.
By using a mutual fund, your portfolio is going to be managed by experts in the municipal bond industry. Additionally, you’ll get greater diversification for smaller amounts of money than if you try to buy the individual bonds themselves.
The downside of using a mutual fund may be the slightly higher cost of managing the portfolio, as well a greater risk of a decline in value or interest earned. This holds true even if your bond fund buys all AAA-insured municipal bonds, because the mutual fund may be forced to sell some of its position before the bonds actually mature.
2. General Obligation versus Revenue Bonds
There are two main types of municipal bonds, with the difference arising in how money is collected to pay back the interest and principal back investors. The interest that you receive from a general obligation bond is included in a city, county, or state budget. It is funded out of income and sales tax collection, and is one of the municipalities highest obligations.
The interest paid to investors on a revenue bond is funded by some type of underlying municipal enterprise, such as a toll road or water department. If the revenue does not come in, the investors generally do not get paid.
The difference between these two types of bonds becomes negligible if the municipality purchases outside insurance on their bonds. This insurance helps to ensure that even if the county cannot meet its obligations, the investors will still get paid.
3. AAA-Rated versus Lower Quality
One of the great truths of investing is, “the more you risk, the more you can earn”. Municipal bonds are no different.
There are cities and counties that are in less than perfect financial shape, and thus they are more likely to default on their bond payments. To entice investors to buy their bonds, they have to offer a higher rate of interest than the safer municipalities.
While there are some very attractive yields on bonds rated less than AAA, you need to consider carefully the interest and principal risk you are assuming. For higher risk bonds such as these, a “high yield” mutual fund is a worthwhile alternative, since it spreads your risk among numerous issuers.
4. Zero Coupon, Taxable, and AMT Municipal Bonds
For investors really looking to maximize their municipal bond return, there are some sophisticated alternatives to consider. However, all of these come with their own unique risks that should be examined carefully.
Zero coupon bonds are bonds that do not pay interest year to year. Rather, they are issued at a deep-discount to what they will eventually mature at. The difference between your purchase price and the maturity value is your investment return. These generally offer a higher rate of return than coupon bonds, but also experience much more volatility in their price right up until they mature.
Taxable municipal bonds are bonds that do not receive the Federal exemption from taxation because they fund certain activities like sports stadiums. They often offer taxable yields slight higher than Treasury bonds, and are the once exception to the rule against using muni’s in a tax-favored account.
AMT bonds are bonds that receive the Federal tax exemption, but whose interest might be subject to the Alternative Minimum Tax. Since they offer a higher yield then non-AMT bonds, they are a great option to consider for someone who is very sure they will not be subject to the Federal Alternative Minimum Tax.
Before you start building your municipal bond portfolio, here are some other resources to take a look at:
Muni Bond 101 on E-Personal Finance
Tax-Equivalent Yield Calculator