Tax-free municipal bonds offer a means of investing without having to worry about paying taxes on the bond. They are known as municipal, because you buy them in a municipality. Municipalities include states, towns, schools, and cities. They are always exempt from federal taxes and may or may not be exempt from local and state taxes depending on where you live and where you buy them. There are two main types of these investments; General obligation and income. Each has its own advantages and disadvantages that must be carefully weighed.
A bond broker is a solid way to see what is available in your area and can provide information to help you make a quality decision. A general obligation bond is the most common and offers the best rates. These are often tax-guaranteed and the preferred investment due to the lack of high risk. An income bonus is based on the ability of a single facility or program to generate the funds. Some examples include utility companies and their ability to increase usage rates, bridges and toll rates, and hospitals; All of these areas can easily raise the money to pay for the investment value, and are therefore safe, but not as safe as a general obligation bond. The fact that tax-free municipal bonds have a good level of security is offset by the lower interest rates, compared to high-risk investments.
An Alternative to the Stock Market
Due to the turbulence in the stock market in recent years, many investors are looking for alternative investments that have less risk. Tax-free municipal bonds are worth considering as an alternative to the market. They generally have less risk than stocks and mutual funds. They also have the advantage of earning income without incurring taxes, which makes them attractive to those who pay high taxes. They also do not incur state and local taxes in most states, especially if purchased in the same state as the city issuing the bond. For investors looking to reduce their tax bill, they are an excellent option. They have enjoyed tax-exempt status since the inception of income tax in 1913. They are also safe investments, and municipalities historically have extremely low default rates on these municipal bond debt obligations. You will almost certainly receive your principal back in full, as well as the interest payments with one of these investments.
Investment Options and Terms
For those who have never explored this type of investment, it is best to consult a bond broker who can explain all the advantages of this transaction. A broker can also identify the different investment options and terms, as well as how it is a great way to diversify your investment portfolio. Consider buying in your state first, before looking elsewhere; The reason for this is that you will often be exempt from state and local taxes. Supporting your community and local is an added benefit to tax-free municipal bonds and most portfolios should contain them. The quality performance with the low risk makes them a solid foundation for any portfolio of serious investors.
How to Invest in a Tax-Free Community
As you drive down a road and pass this new, state-of-the-art stadium, you might be wondering how your city paid for it. It is very likely that a municipal bond made it possible. Municipal bonds, also known as munis, are debt securities issued by state and local governments to finance necessary infrastructure. They are often used to build hospitals and roads, improve schools, or start public construction projects. Muni bonds are also popular with investors. They can earn a steady income and are generally exempt from federal taxes, as well as most state and local taxes, making them especially attractive to those in higher tax bracket.
How Muni Bonds Work
Municipalities issue a loan when they need to raise money for a project. An investor who buys a Muni bond finances that particular project for a specified period of time. Expect interest or coupon payments (usually semi-annually) and the original principal amount when the bond matures or when the loan term ends. There are two main types of Muni bonds, and they differ from where they get the money to pay investors.
- A general bond or GO bond is generally backed by the local government of a municipality with an unconditional promise of repayment. You could pay your investors out of a general fund or through a special local tax.
- An income bond uses the money generated by the project to meet its debt obligations. Examples include a bridge or tunnel that charges tolls or a stadium that uses ticket sales to pay interest and principal to investors. Sometimes a municipality issues a tax certificate on behalf of a private entity, such as a university, a real estate developer, or a health care system. These are known as line ties. In these cases, the conduit borrower has the ultimate responsibility to meet the debt obligations.
Advantages of Muni Bonds
Tax Minimization: Many municipal bonds are exempt from federal taxes, and if the investor lives in the same state the bond is issued in, the municipal is often exempt from state and local taxes as well. This is especially beneficial for investors in a higher tax bracket, as the tax exemption increases the bond’s yield. You may see a calculation of the tax equivalent yield on a Muni bond, or TEY, that investors can use to compare the yield of a municipal bond with that of a taxable bond.
Here’s how this calculation works:
TEY = tax-free Muni bond yield / (1 – investor’s current marginal tax rate)
For example, if an investor in the 35% tax bracket buys a Muni bond with a 4% yield, the calculation would be 4 / (1 – 0.35) and the TEY of the bond would be 6.15%. An investor would need to find a taxable bond with a 6.15% yield to be comparable to this Muni bond.
By considering where to buy Muni bonds, investors can save on taxes. For example, many investors in higher tax brackets buy strategically tax-exempt munis from their brokerage accounts, which are taxable. They put their other less tax-exempt fixed income investments into retirement accounts like traditional IRAs and 401 (ks), which are designed to defer taxes.
Diversification: When it comes to investing, it makes sense not to put all your eggs in one basket and instead diversify your holdings. This helps minimize investment risk in your portfolio. Investors often use Muni bonds in conjunction with Treasuries, corporate bonds, and other fixed income securities because they all have different risk and reward profiles. Generally, a Muni bond carries slightly higher risk and a higher yield than a government bond, but is less risky and has a lower yield than a corporate bond. Many municipal bonds can also be considered socially responsible investments if the project they finance is aimed at social welfare or community development.
Safety: Municipal bonds are considered a relatively safe fixed income investment. According to research firm Moody’s, the cumulative default rate for investment grade Muni bonds averaged 0.18% between 2007 and 2016, compared to an average of 1.74% for investment grade corporate bonds. .
GO bonds are generally considered safer than revenue bonds because a municipality can collect taxes to cover outstanding debt obligations, while revenue bonds depend on the income from the project in question. Income bonds can also be “non-recourse,” meaning investors would remain high and dry if project income did not meet expectations.
Muni Bond Risks
Standard Risk: While these bonds are a relatively safe investment, local governments can sometimes find themselves in financial trouble. You may remember the headlines about the default settings in Detroit in 2014 and Puerto Rico in 2018. Such defaults are rare and you can combat the risk of default by researching the community and verifying the creditworthiness of the bond you are interested in. Rating companies such as Moody’s, S&P and Fitch assign ratings to help investors assess the risk of any bond. In addition, the Municipal Securities Regulation Board, a regulatory authority, maintains a Website with disclosure documents, pricing data, and other valuable information for Muni Bond investors.
Interest rate risk: Like their other fixed income counter-parties, Muni bonds are generally inversely related to interest rates. So when interest rates go up, bond prices fall and vice versa. If you buy a bond and then interest rates rise, you will get a lower return than you would by buying a new bond at the higher interest rate. Therefore, the price or market value of your bond goes down as your bond is worth less. On the other hand, if you buy a bond and interest rates drop later, the price of your bond goes up because you have obtained a higher return than if you bought a new bond at the lower interest rate.
Call risk: Some Muni bonds are redeemable, which means that the issuer can choose to redeem the bond before the maturity date. When interest rates drop, an issuer with the option to cancel its bond may choose to do so, as the issuer can save money by refinancing or reissuing another bond at a lower interest rate.
How to Invest in Municipal Bonds
The capital market for Muni bonds has grown over time, reaching a whopping $ 3.9 trillion in 2019. If you think they have a place in your portfolio, there are a few ways to get started. You can buy individual Muni bonds or Muni funds from your online brokerage account, and many robo-advisors offer Munis as part of their portfolio mix.
Simple Bonds: Many investors who buy Muni bonds have a buy and hold strategy that they want to stick to until maturity. These investors can research and select the bonds that best suit their portfolio in terms of risk and return, maturity, and tax benefits.
Municipal Bond Stairs: If you buy and hold a simple bond, you won’t get your principal back until the bond matures. Some Muni bonds have a term of one to three years, while others have a term of 20 or 30 years. Investors who need a steady income might consider buying multiple bonds and building a ladder, with the bonds maturing annually or on a term that suits their situation and cash flow needs.
Muni Fund: For those who are not comfortable choosing municipal bonds for themselves and investing in Munis all over Mutual Funds or Exchange Traded Funds, also known as ETFs, may make sense. One advantage is access to a well-diversified portfolio of municipal bonds with different ratings, a variety of projects and bond types (GO or income), and different risks and returns. This will reduce the potential risk of default by spreading your money over many bonds.
Another benefit is transferring the responsibility to someone who knows municipal bonds well, that is, the fund manager, to keep an eye on the municipalities and the risks to you. Some investment management companies offer country-specific funds so investors can take advantage of both federal and local tax breaks. Even if you can’t find a country-specific Muni fund that is right for you, a national fund can provide at least an exemption from federal taxes.