This is a guest post about municipal bonds from JT, who blogs about business, finance, and proper money management at MoneyMamba.
We all know the Joneses; they’re the family we’re not supposed to chase when thinking about our budgets. But now the Joneses are back, and you might just be chasing them in your investment portfolio.
Municipal bonds
Municipal bonds are debt instruments issued by local governments. When a city, locality, or government agency wants to build new roads, bridges, stadiums, or simply fund a local government for the next year, it often issues municipal bonds to raise money.
Municipal bonds are attractive to investors for three reasons:
1. You can make a difference locally, and invest in a debt obligation backed in a small city or town. This sense of “feel-good” investing makes us all warm inside. Municipal bonds are as American as apple pie in this sense.
2. Ignoring current budget constraints, municipal bonds have the second lowest default history. “General obligation” municipal bonds are even safer, since the payments on such bonds are guaranteed by the taxing power of the city.
3. They are a tax-exempt investment. This means that the income you earn from holding a bond is not taxed at the Federal level, and in some cases, at the state level as well.
The combination of feeling great about funding local initiatives and avoiding the IRS at the same time is a deadly one. Often, investors chase the combination in what is nothing more than the investing version of keeping up with the Joneses.
Are tax-exempt investments right for you?
Tax exemption sounds absolutely awesome. And it’s the reason why so many people think that municipal bonds are the best investment for their portfolio. However, in many cases, municipal bonds are best left for the very rich.
Because municipal bonds are tax-free, investors in the highest income tax brackets tend to favor municipal bonds over other investments.
Consider this example: You have income in the 15% tax bracket. Mr. Jones has income in the 35% tax bracket. For the sake of science, we’ll say municipal bonds currently yield 4%.
The two scenarios look like this:
• Your situation – Investing in a tax-exempt municipal bond at 4% is much like investing in a taxable bond yielding a little less than 4.6% per year. After tax code consideration, a little less than a 4.6% annual yield in taxable investments is the same as 4% tax-free.
• The Joneses’ situation – Investing in a tax-exempt municipal bond at 4% is much like investing in a taxable bond yielding 5.4%. The Joneses’ would receive the same amount of income from a 4% tax-exempt investment as they would a taxed investment yielding 5.4%.
The Joneses get a better return with municipal bonds than you do because they have income in a higher tax bracket. They can afford to take a lower rate on municipal bonds than you can, and as a result, they pay more for muni bonds. In efficient market hypothesis language, the tax-code differences are priced into the market.
Know your advantage
When we compare two investments, we should take into consideration each investment’s advantages. We should also look to see if these advantages are priced into the market.
Right now 5-year AAA-rated municipal bonds yield 1.06%. At the same time, 5-year AAA-rated corporate bonds yield 1.30%. (This data can be found at Yahoo Finance.)
The duration is the same, each of 5 years. The rating and safety are virtually the same. The only thing different from a municipal bond, from a high-level view, is the tax code difference. For municipal bonds to be worth your while, you would have to have income in the 25% tax bracket.
Pending that you don’t have income in the 25% tax bracket, you would be best to invest in taxable investments, since the market has priced in a plus or minus 25% difference in yields between municipal bonds and corporate bonds. Think of it as high-income folks are bidding down the yields to account for their tax code advantages, not yours. The rich have a leg-up on you in municipal bonds, and they use it!
Bottomline: Saving money in taxes is great, but not if it means that you lose MORE in income. The highest earners can afford to invest in lower-yielding bonds than you can, but on the upside, you can afford to invest in higher-yielding taxable bonds than they can.
Perhaps more importantly, it’s never a good idea to buy tax-exempt investments in a tax-deferred retirement savings account like a 401k or IRA. If you were to do so, you would be paying for a tax advantage that you don’t need.
Keeping up with the Joneses’ can cost you in more ways than one.
Have you invested in municipal bonds? What’s your take?
As a Canadian, I think the tax incentive to buy bonds is a great idea. In Canada our provincial and federal bonds get taxed at our full marginal rate if they are not put in a tax-advantaged account. It really makes sense though to hold bonds from a wealth management perspective in the USA. How is the interest on corporate/junk bonds taxed?
As we are now retired, we are in progress with moving more of our allocation into bond investments.
My experience with muni bonds leads me to suggest:
- invest in muni bonds instead of an IRA (you can put as much as you want into them, they are tax free – not deferred, and you have no restrictions)
- don’t buy a muni bond through your broker – get a new one
- don’t buy a muni bond that can be called (especially don’t buy one that can be called through your broker at a premium!)
- so far, we are liking bond funds
- look for bond funds that are ‘double tax free’ (invest in muni bonds from your state)
- watch out for the AMT!
I knew next to nothing about Muni bonds, so I appreciated this post (and your comment as well, Marie). Tax considerations aside, my question for your guys is how safe do you think Muni bonds are, with local governments in such financial disarray right now?
@My University Money – It’s a good idea in my opinion, too. In the US, taxes on corporate bonds are taxed at income tax rates. There’s no savings there. Junk bonds being the same, as they’re just lesser rated securities.
@Marie – I agree with most of what you suggest. Buying them in an IRA is silly, since you’re putting tax-advantaged investments in a tax-advantaged account. It’s a waste of space in an IRA that could be used for other investments. Great point on double tax-free bonds. Bonds from a broker aren’t necessarily bad, but brokers have an incentive to recommend high-yield bonds from a state that may not be a good investment…that all comes down to the broker. Thanks for your insight as these are very important points for people looking to get into muni bonds.
@Julie – Net-net, I think corporate debt is safer. Painting with broad strokes here, but “general obligation” municipal bonds are the best munis since the funds to repay the bond aren’t from a single source. Instead, it’s a general obligation, meaning that all unallocated tax revenue can go to paying for the bond. It also means that a municipality can simply raise taxes to make debt payments.
Municipalities have their own problems, and for investors a major concern is the fact that things can get a little political. On the other hand, corporations have a record amount of cash on their balance sheets, virtually guaranteeing that all short-term bonds will not go into default. As a general rule, I’d leave municipal bonds for the people who have really high incomes and the money to pay someone to do an in-depth analysis on city budgets. Corporations are easier to study, and better yielding for people in lower tax brackets.
Hope that helps!
P.S. – I’m not a registered broker, or finance professional. These are just my opinions.
I have not invested in muni bonds yet. Maybe because I don’t trust my local government!
Very informative post- great job.
Muni’s are more secure than Corporate bonds in my opinion. Particularly if you only buy those noted as insured. But even the Insured option has doubters so if you want most of the benefits of municipal bonds and the smallest amount of risk buy either mutual funds or ETF’s. Vanguard has both, which I have owned a long time, but I also own PZA and TFI. I bought them during some muni bond bashing so I gained in capital in addition to 3 or so percent tax free income which beats cash. I definitely support the suggestion of contrarian investing recommended in this post.
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