Who Should Consider Investing?
Not all diversified portfolios are created the same. Each requires a tailored mix of asset classes, namely stocks and bonds. Stocks drive the growth of a portfolio, whereas bonds provide income and capital preservation. Not all bonds are structured the same. Typically, corporate bonds offer a higher yield, but, depending on the tax characteristics of an account or account holder, lower-yielding municipal bonds may be preferred.
What are municipal bonds?
Municipal bonds are a form of debt issued by a state or municipality to fund public works projects. As with treasury and corporate bonds, when you purchase a municipal bond, you’re lending money to the issuer for a fixed period. In exchange, the issuer pledges to pay you interest over the life of the bond and return your principal when the bond matures. Those interest payments are generally taxable to the investor.
There are two types of municipal bonds:
- General obligation bonds – General obligation bonds are used to fund projects that serve the public community but don’t necessarily generate revenue. Examples include schools, parks, and bridges. General obligation bonds are one of the safest types of bonds because they’re backed by the full faith and credit of the municipality. Because the municipality has taxing power, it can raise rates or levy new taxes in order to pay bondholders.
- Revenue bonds – As the name suggests, revenue bonds are issued by municipalities to finance revenue-generating projects. Examples include toll roads, utilities and concert halls. The revenue generated by the project is then used to pay back investors. Because revenue bonds depend on future cash flows from projects that aren’t yet complete, they’re riskier than general obligation bonds. It’s important to fully understand an issuer’s credit rating and past default rates before investing in a revenue bond.
Benefits of municipal bonds
There are several benefits associated with investing in municipal bonds.
- Low default rates – The default rate of municipal bonds is significantly lower than that of corporate bonds. In fact, the five-year all-rated cumulative default rate (CDR) of municipal bonds from 1970 to 2020 was 0.08%, compared to a five-year CDR of 6.89% for global corporate bonds over the same time period.1
- Tax-free interest – The largest benefit of investing in municipal bonds over corporate bonds is the tax-free interest they provide. Although the stated interest rates paid by corporate bonds are typically higher, interest payments are reduced by federal (and, potentially, state) taxes. In contrast, most municipal bonds are exempt from federal taxes. In order to compare the two, you must find the tax-equivalent yield.
You can find the tax-equivalent yield of a municipal bond by dividing its yield by 1 minus your tax rate, potentially including state taxes if the project is in your home state. This will provide the equivalent rate used to compare municipal and corporate bonds. For example, if you fall into the 35% federal income tax bracket, you will need to find a corporate bond with a 4.62% taxable interest rate in order to achieve a yield as valuable as a 3%-yield municipal bond. This is because 3/(1-0.35) = 4.62.
- Predictable, tax-free income in retirement – Municipal bonds typically pay interest twice per year, which can help enhance a retiree’s tax-free income stream.
Who benefits most from an investment in municipal bonds?
Investors who stand to benefit most from municipal bonds include those with high incomes living in states with high state and local income taxes. Those living in states with no income tax will not benefit from the state tax exemption; however, they can purchase municipal bonds from other states without paying additional taxes to the issuing state.
As with all investments, municipal bonds carry their own set of risks and drawbacks. Your wealth manager can help you determine if an investment in municipal bonds makes sense for your particular financial situation.
For more information about municipal bonds, or for assistance with any other financial matter, schedule a call with a member of our team.
