“Nothing is certain except for death and taxes.” – Benjamin Franklin
Virtually all investment income outside of a qualified retirement account is taxable, except for income from tax exempt municipal bonds. Municipal (or “muni” for short) bonds are often overlooked, but can be an excellent cornerstone in taxable fixed income portfolios. Most investors think of munis as a boring investment found in your grandfather’s portfolio, but there is nothing boring about paying less in taxes than you have to. A well-crafted muni bond portfolio provides stability, diversity, and tax-exempt income. Investors in the top three tax brackets who own taxable accounts have an opportunity to generate greater tax equivalent yield in munis than other types of fixed income investments with similar credit quality. With the U.S. government staring at unprecedented fiscal shortfalls, it wouldn’t be surprising to see income taxes for higher earners increase, providing strong rationale for including tax exempt munis in non-qualified accounts.
What are municipal bonds?
Municipal bonds are debt securities issued by states, cities, counties, and other governmental entities to fund day-to-day obligations and to finance capital projects such as highways, schools, or sewer systems. The majority of munis pay interest that is exempt from federal income tax. Interest may also be exempt from state and local taxes if you live in the state where the bond is issued. The most common types of munis are:
-General obligation bonds issued by states, cities or counties and not secured by any assets. Instead, they are backed by the “full faith and credit” of the issuer, which has the power to tax residents to pay bondholders.
-Revenue bonds not backed by the state government’s taxing power, but by revenues from a specific project or source, such as highway tolls, water/sewer system revenue, or building lease fees.
-Bonds issues by other entities such as hospitals, non-profit colleges, sports stadiums and special development projects.
What are the potential advantages of buying munis instead of treasuries or corporate bonds?
One potential advantage is higher quality. The 50-year annual default rate for AA and AAA-rated munis is .03%. When a big municipal bond issuer defaults, it receives A LOT of attention in the financial press because it happens so rarely. The second advantage is higher yield. For tax exempt investment grade munis, after tax equivalent yield is often higher than treasuries or corporate bonds.
The formula for computing what a tax equivalent yield is pretty simple:
Investors might initially see lower tax exempt muni yields and have a reaction similar to taking a shot of 100 proof tequila. However, the actual after-tax yield is based on the simple formula above and offers an apples-to-apples comparison to taxable bonds.
Aren’t some munis in trouble because of COVID-related revenue shortages?
As with any investment, you should never buy certain types of munis without doing some homework. Muni issues backed by transportation, sales tax, and university tuition revenue are probably best avoided for now. The safest issues are backed by essential services. For example, bonds relying on water/sewer revenue have long been considered one of the safest types of munis because water is essential to everybody. Also, most large state and local government issues backed by property or income tax revenues are typically very safe. Munis backed by revenue from special development projects for retail and entertainment districts, convention centers and sports stadiums are much riskier, but pay higher yields.
What else should I be concerned with?
The biggest challenge for fixed income investors today is record low interest rates. The Federal Reserve has signaled they will support low rates for the foreseeable future. However, at some point, rates have the potential to rise and further complicate fixed income investing. Longer maturity bonds will decline in value much more than shorter maturity bonds if rates increase. In this environment, the risk/reward profile favors bonds with maturities of less than 10 years. Also, in the event rates happen to decline, be aware of callable bonds because this provides all of the advantages to the bond issuer who will likely call your bonds away. This forces you to reinvest in lower yielding bonds. Give free money to your favorite charity instead of muni bond issuers. Most munis with longer than 6-year maturities are callable, but one way to diminish the downside is to buy bonds with no more than two years’ window between the first call date and maturity. Unfortunately, many muni funds have too much duration and are overloaded with wide window callable bonds to artificially juice yields.
Munis tend to fly under the radar for a lot of investors, but there are plenty of reasons they shouldn’t. Who wouldn’t like to lower their tax bill and get more yield in high quality bonds? In the next blog, we will examine the best ways to get exposure to munis by looking at pros and cons of individual bonds vs. muni funds.
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Brian Murray MBA, CFA is an Investment Advisor at The ETF Store. He has 23 years of experience as a fixed income portfolio manager for multibillion-dollar institutional portfolios. He helped develop the fixed income department at a $55 billion investment advisory firm where he managed hundreds of portfolios for individual investors.