Municipal Bonds: A Tax-Friendly Way to Put Capital to Work

Muni bonds (or munis) are unique investments in that the interest is generally exempt from federal income tax, as well as from state or local taxes if you live in the state where the bond was issued. For this reason, they have long been a mainstay in the portfolios of income-focused investors who want to manage their tax burdens. The tax-free income offered by municipal bond investments may look even better to investors in high-cost states, partly because the federal deduction for state and local taxes (SALT) is limited.*

Even though a muni’s coupon rate may be lower than that of a comparable taxable bond, its after-tax yield could be higher. Of course, the extent of the tax savings depends on your tax bracket. For example, a 5% tax-free yield is equivalent to a taxable yield of about 7.9% for an investor in the 37% bracket and 6.6% for an investor in the 24% tax bracket.

The equivalent taxable yield would be even higher if you are subject to the additional 3.8% tax that applies to net investment income for individuals with adjusted gross income of more than $200,000 ($250,000 for married couples filing jointly), or if your muni income is exempted from state income taxes.

Tax details

Keep in mind that some municipal bond interest may be subject to the alternative minimum tax (AMT), and tax-exempt interest is included in determining if a portion of any Social Security benefit you receive is taxable. If you sell a muni bond for a profit, you could incur capital gains taxes.

If a bond was issued by a municipality outside of the investor’s state of residence, the interest may be subject to state and local income taxes. Some states tax both in-state and out-of-state munis, and some tax neither. Consider consulting a tax professional before investing to make sure you understand the state and federal tax implications.

Government borrowing

Tax-exempt municipal bonds typically fall into one of two categories. General obligation bonds are issued to raise capital immediately, usually to cover expenses or refinance public debt. They are commonly repaid through taxes levied by the issuing agency. Revenue bonds are issued to fund specific revenue-generating projects (such as utilities, non-profit hospitals, event facilities, public transportation, and toll roads) and are typically repaid from the revenues generated by the finished projects.

If a municipality issues a bond to finance a project that primarily benefits private investors, it is considered a private-activity bond (PAB) and the interest is generally taxable at the federal level. For example, a new football stadium may serve a public purpose, but team owners (not taxpayers) are likely to reap most of the financial benefits. The interest offered by qualified PABs — which must meet strict IRS criteria — is tax-exempt (but might still be subject to the AMT). These bonds may be issued for projects that meet public needs such as affordable housing, airports, and waste disposal facilities.

Risks and ratings

Governments have the power to raise taxes and fees as needed to pay interest, so municipal bond defaults have been relatively rare compared with corporate bonds (which are taxable) on a historical basis — although there have been some high-profile municipal bankruptcies.¹ As a result, municipal bonds are generally considered less risky than corporate bonds with similar maturities, and they tend to offer lower interest rates, partly because corporate bond investors need to be rewarded for taking on greater risk.

Regional economies and the financial strength of issuers can vary widely, and like all bonds, municipal issues are rated for credit risk. A range of AAA down to BBB (or Baa) is considered “investment grade,” while lower-rated or “junk” bonds carry higher risk. Some lower-rated municipal bonds are insured, with a separate credit rating for the insurer. If an issuer’s credit rating changes for better or worse, it often causes a corresponding increase or decrease in the value of the issuer’s bonds.

Another risk is that changes in the economy, such as an increase in inflation and interest rates, can reduce the value of your bond. As interest rates rise, bond prices fall, and vice versa. That’s because investors aren’t as interested in buying an old bond with, say, a 5% interest rate if they can buy a newer bond issue that offers 6%. On the other hand, if interest rates fall and new bonds are being issued with a 4% interest rate, an older bond that pays 5% becomes more valuable.

Regardless, if a bond is held until it matures and the issuer doesn’t default on it, you will receive the interest owed on the bond from the date of purchase plus the full principal. However, if a bond is sold or redeemed prior to maturity, it could be worth more or less than the original cost.

If you will be relying on income from a bond, you’ll also want to consider whether it’s callable — i.e., if it includes a provision that lets the issuer retire the bond early by repaying the loan in full. Because of call risk, callable bonds may offer a higher yield or a call premium that will be paid only if the bond is called. When estimating a callable bond’s yield, you should know its yield to maturity and its yield to call, which is based on the earliest date the bond could be called. A period of falling interest rates increases the likelihood of a bond being called, because the issuer may be able to refinance the debt at a lower rate.

Individual bonds or funds

You can invest in individual municipal bonds directly or through separately managed accounts, or you might prefer to buy shares of mutual funds or exchange-traded funds (ETFs) that invest in municipal bonds.

If you buy a municipal bond when it’s first issued, you will pay the face value, and most bonds are sold in denominations (or multiples) of $5,000. Bond interest typically is paid every six months (though some types of bonds work differently). When bonds are exchanged on the secondary market, prices are expressed as a percentage of the face value of the bond, which is called par (100%). A bond may be purchased at a premium (above par) or at a discount (below par). A bond’s interest rate and maturity will affect the current price, as will the balance between supply and demand in the bond market.

When you buy shares of a municipal bond fund, your assets are pooled with those of other fund shareholders. Professional fund managers pursue stated objectives when selecting and managing bond investments. Purchasing fund shares helps spread risk across many individual bonds. Some muni funds are national and offer income free of federal income taxes but may be subject to state and local taxes. Other funds focus on bonds from specific states and may also include bonds from U.S. territories such as Puerto Rico and Guam that are not subject to state taxes, making the fund’s interest income tax-free for investors who live in the targeted state. When you sell shares of the fund itself, you’ll incur a gain or a loss depending on your cost basis, the amount of your initial investment, and any reinvested dividends.

If you are interested in a customized investment approach, you might consider a separately managed account (SMA) — a professionally managed individual investment account in which you can hold bonds. In an SMA, your assets are not commingled with those of other investors. This may allow you to better manage your tax liability, set investment guidelines, or exclude certain bonds based on your personal priorities and circumstances. With an SMA, your financial professional may rely on a separate asset manager (perhaps a bond specialist) to handle the day-to-day portfolio decisions. An SMA must be managed by a registered investment adviser, who may be independent or part of the same firm as your financial professional.

Unlike traditional brokerage accounts, which are commission based, SMA fee structures are asset based. They typically cover the investment management fee, trading costs, custody, reporting, and other financial services. There is no guarantee that working with a financial professional will improve investment results.

Bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. The return and principal value of bonds and fund shares fluctuate with changes in interest rates and other market conditions, which can adversely affect investment performance. Any capital gains earned by the fund are taxable, and any capital losses may generate a tax benefit.

Funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional.