One potential investment option is Municipal bonds. They are stable, income-producing vehicles that are primarily used to fund local and state government projects, such as buildings and highways. One positive attribute is that they are tax-free for federal tax purposes. The question becomes – are they right for you, and what else should be weighing in on your decision about whether or not to invest in tax-free municipal bonds?
How do municipal bonds work?
From a tax perspective, if you buy bonds issued by your state or local municipality, you may not be required to pay the corresponding state or local taxes that a nonresident would have to pay. This characteristic makes certain municipal bonds (“munis”) triply tax free. From an investment perspective, munis do have lower yields than their corporate-backed equivalents which needs to be considered in your decision.
In making your decision, it is wise to compare the yields of taxable investment-grade and government bonds with comparable maturities by using the tax-equivalent-yield formula below:
(tax-free yield) ¸ (1-tax rate)
This calculation gives you the real, post-tax net yield of a corporate bond, which you can then compare to the yield of a municipal bond. This makes the comparison apples to apples. History shows that higher income investors who have higher tax bills benefit more from municipal bond yields than investors who are in the lower tax brackets.
Take a closer look
The principal of municipal bonds, like with other types of bonds, is inversely proportionate to interest-rate fluctuations. Debt securities (bonds) with longer maturities incur greater fluctuations in market value over their maturities as the interest rates rise and fall. During low-interest-rate times, there is a risk to the bond’s principal because interest rates are more likely to rise in the future. This will cause a decline in the principal of the bond, and investors can suffer losses to the principal if they sell a bond prior to maturity.
Depending on the inflation rate, a municipal bond could offer real returns in some years and barely keep pace with inflation in other years. History indicates investing solely in low-yielding munis, though safe, will create minimum growth, if any, in your investments. With that in mind it is best to have a balanced portfolio of bonds and equities to help offset the potential risks of eroding purchasing power.
How safe are they?
It is rare that states or municipalities default on their bonds, but it does happen. Look at the debt crisis in Puerto Rico, which defaulted on four bonds, effecting $22.6 billion in debt. The territory has stated that it will reduce $35 billion in bonds and other claims by more than 60%. Be advised not all munis are insured. Only 5.6% of new municipal bonds issued in 2019 were insured, compared with 46.8% in 2007.
Municipal bonds can offer potential advantages and downsides to investors. These bond issuances tend to be highly rated and have low refinancing risk, low default rates, and a low historical correlation with other major asset classes. But very few insured bonds are coming to market, so there’s a greater need to do your homework.
Whether tax-free municipal bonds make sense for you depends on your income, investment goals, and risk tolerance. Work with financial and tax professionals to see whether munis are right for you.
If you need assistance or have any questions on the information in this article, please call your CironeFriedberg professional. You can reach us by phone at (203) 798-2721 (Bethel), (203) 366-5876 (Shelton), or (203) 359-1100 (Stamford) or email us at info@cironefriedberg.com.
