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 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?