By: Investor Solutions, Inc.
Unless you’ve spent the last ten years in a cave, you’re likely to have heard about the tax advantages that many municipal bonds (muni bonds) can offer to investors. But when exactly does investing in a municipal bond or bond fund make sense? How do you know when it’s time to dump your taxable fixed income interest for some tax breaks? If you’re living in a high income tax state such as New York , California , Oregon , or Maine , the decision to invest your fixed income allocation in municipals can be a no-brainer.
When you talk about municipal bonds you’re referring to debt instruments that are issued by the states, counties, parishes, cities, and towns. The two types are General Obligation Bonds and Revenue Bonds. General Obligation Bonds are backed by the full faith and credit of the government issuing the debt security, and are repaid through the taxes collected by the issuer. Revenue Bonds on the other hand, are more risky than the GO Bonds as they are not backed by the full faith and credit of the issuer. The debts are repaid from the revenue generated from the project that was financed (i.e. stadiums, toll ways, etc.) Generally, revenue bonds and bond funds with longer and more risky projects will require higher yields.
The beauty of municipal investments is that the interest earned from the municipal bonds is not subject to federal income tax. In most cases, if the investor is a resident of the state that issued the bonds the interest is also exempt from state taxes. Some cities/localities even go a step further and exempt the interest from local taxes as well. Triple Tax-Free, what a great deal! However, if a municipal bond is sold, any gain or loss is a capital gain or loss and, therefore, subject to federal income tax. Under the Internal Revenue Code, if a municipal bond is called or matures, a capital loss cannot occur. Any premium that is paid for a municipal bond is required to be amortized.
Keep in mind that when interest rates go up, bond prices go down and vice versa. The longer the maturities in your bond holdings the greater your risks of price fluctuation of the bond/bond fund. Municipal bond investments work the same way. In order to determine if a municipal bond investment makes sense for you, you’ll need to compare it to a similar taxable investment (similar maturity taxable investments). You do this by computing the Tax-Equivalent Yield from the current yield of the municipal bond. I’ve calculated a few examples for you in Table 1 below: Table 1
The Taxable Equivalent Yield:
Municipal Bond Yield
Using this chart, an investor in the 25% tax bracket looking to purchase a municipal bond investment that is currently yielding 6.0% would have to find a comparable taxable investment yielding 8.0% or greater to come out ahead. The formula is the following:
Tax-Equivalent Yield = Muni Yield / 1-Tax Rate
Let’s say you’re a 33% taxpayer residing in California and you want to include your state income tax rate of 9.3% and your local tax rate of 2.7% (total 45%) in your calculation. You’re considering a municipal bond investment that yields 6% (triple tax-free), what yield must a taxable investment provide in order to be more attractive? Computing this, your tax-equivalent yield equals .06 divided by 0.55 (1-.45) which equals 10.9%. So, you must find a taxable investment that yields 10.9% or better, otherwise stick to the muni.
Surely like everything in life, there must be some downside to investing in municipal investments. Well, municipal bonds can be both public and private activity bonds. While municipal bond interest is not subject to regular tax, large amounts of private activity bond interest may subject a taxpayer to the AMT tax. To be considered a private activity bond (which may subject you to AMT) it must meet both of the following: 1) more than 10% of the proceeds of the issue are to be used for private business use, and 2) at least 5% of the proceeds are used for loans to parties other than the governmental units. An example of this would be a sports complex or stadium. Also, individual municipal issues are sometimes difficult to liquidate resulting in higher than normal commission/trading charges. Owning a pooled municipal mutual fund can help eliminate the upfront commission charge, however; you’ll then subject yourself to the operating expenses charged by the mutual fund. You’ll find some of the best municipal mutual funds at Vanguard, Fidelity(Spartan), and DFA, since they eliminate any type of sales load and typically have the lowest operating expenses of all the mutual fund families out there.
Another drawback is that most municipal investments have maturities of greater than 3 years, so this means you’ll need to expose your fixed income portfolio to intermediate or long term bond holdings, not exactly the kind of exposure that you might want in a rising interest rate environment. Lastly, for those of you deducting your investment management fees as a miscellaneous itemized deduction, a municipal investment will kill that ride. Investment management fees attributable to tax-exempt holdings (municipal bonds or funds) are not deductible. For example, if your advisor charges you a 1 percent fee based on your portfolio’s value and 25 percent of your portfolio is in municipals, then 25 percent of your management fee is not deductible. The other 75 percent of your portfolio in taxable investments will still qualify for the deduction.
Tax-exempt municipals are traded over the counter and they are generally available through most discount brokerage firms just like taxable stocks, bonds, and mutual funds. Like commercial bonds, municipals are also rated by services such as Moody’s and Standard & Poor’s. Typically, a good credit rating will offer lower interest rates than an issue that has revenue deficits or similar problems. Study the rating, maturity, duration, and tax-equivalent yield of the issue before you invest in the municipal bond or municipal mutual fund. Mutual funds that invest in municipals are excellent for reducing default risk because they invest in a group of municipal issues thus eliminating your downside exposure linked to the possible failure of a single individual issue. Muni’s have provided exceptional tax advantages to many investors, do your homework and make sure they are a good fit for your portfolio before you invest.