Maintaining a balanced portfolio of stocks, bonds and cash is an accepted and proven method of reducing dramatic swings in value while still pursuing long-term returns. That basic strategy still leaves many decisions in selecting the specific investments, and municipal bonds are worth consideration by many taxable portfolios.
Despite the name, municipal bonds are issued by state and county governments and public educational systems as well as cities. The overall municipal bond market exceeds $2.5 trillion, and the bonds are repaid through tax revenues or revenues generated by public projects. Due to a “mutual reciprocity” agreement between the federal and state governments, interest from federal government securities is not taxed by states while interest from municipal bonds is free from federal taxes. This federal tax-free status reduces borrowing costs for state and local governments and thus offers an indirect benefit to all local taxpayers as well as the direct tax benefit to bond owners.
Most states also exempt the interest from municipal bonds issued in that state from state income taxes, further increasing the tax benefit. (This same break often extends to city and local income taxes, making some bonds “triple tax-free”.) This state tax exemption was recently upheld by the Supreme Court, preserving the incentive for states’ residents to invest in bonds for local projects and preserving the viability of over 500 mutual funds which invest in municipal bonds issued in a single state.
This tax-free status, however, does not extend to capital gains taxes. A capital gain or loss can be created by the difference between the sale price of the bond and the amount the bond owner paid when the bond was originally bought.
Municipal bonds are subject to the same factors as all fixed-income securities. Bonds from lower-quality issuers will have a higher yield, as will bonds with longer maturities. And as interest rates for municipal bonds increase, bond prices will fall; as interest rates fall, bond prices will increase.
There is an important broad distinction among municipal bond issues. “General obligation” bonds are approved by local voters and backed by the full faith and credit of the issuing government. This means the government can use its full taxing power to repay the bond interest and principal. “Revenue bonds” are repaid only from the revenue produced by the financed project – such as a hospital, highway, airport or public housing. Revenue bonds may be considered slightly riskier because repayment relies on the health of the project and the bonds are not considered an obligation of the local government and taxpayers. To compensate for this additional risk, revenue bonds often pay a slightly higher yield than general obligation bonds.
Even worse, some revenue bonds are considered “private activity bonds” which are used to benefit, or finance a facility for the use of, a private business. Interest from these bonds is taxable for purposes of calculating the dreaded alternative minimum tax (AMT). The AMT is a separate income tax calculation that is then compared to the regular tax, and the taxpayer must then pay the higher of the two. The AMT eliminates a number of deductions found in the regular tax calculation in addition to including private activity bond income.
Many municipal bond issuers purchase private insurance which assures the repayment of principal and income. This insurance increases the quality rating and lowers the yield of the bonds. In the pursuit of growth and higher profits, these insurance companies also began insuring other types of bonds such as mortgage securities. The recent mortgage crisis cast some doubt as to whether the insurance companies had the resources to support their potential claims, and insured municipal bond prices dropped in the market. While some of this fear has subsided, insured bonds have not fully recovered and may present an attractive buying opportunity.
To compare municipal bonds with taxable bonds, their tax-free status must be adjusted by calculating the “taxable equivalent yield”. The municipal bond yield is divided by one minus the marginal tax rate, or the rate paid on the last dollar of income. For example, if a high-income taxpayer has a 33% marginal federal tax rate, the municipal bond yield would be divided by .67 to create the taxable equivalent yield. (When evaluating a municipal bond that is also free from state income tax, the marginal state rate should be added to the marginal federal rate.) A 20-year AAA-rated municipal bond is currently yielding around 4.5%, for a taxable equivalent yield of 6.71%. Compare this yield to a 20-year AAA-rated corporate bond, currently yielding 6.25%, and the advantage of municipal bonds becomes clear.
As with other bond investments, municipal bonds can be purchased as individual bonds or through bond funds. Mutual funds offer convenience and diversification at the cost of lower yields (because the funds deduct their expenses from the bond income) and the lack of a specific maturity date at which the principal is repaid. Mutual funds are also more likely to generate an unexpected capital gain when the fund shares are sold. Individual bonds offer higher yields, stated maturity dates and more portfolio management flexibility at the cost of increased risk of particular bond issuers and larger purchase requirements. Selling an individual bond can also be expensive and difficult depending on the market conditions. Finally, some “closed-end” bond funds can offer higher yields by borrowing funds to purchase additional bonds. However, this higher yield is often offset by the greater price fluctuations of the fund due to the borrowing.
Of course, the initial assessment of whether municipal bonds make sense for an investor is the most important. For high-income taxpayers, they can be an ideal component in a balanced portfolio.