If you’re interested in earning tax-free interest from municipal bonds, this short municipal bond primer will introduce you to the basic similarities and differences of munis. Municipal bonds are a type of debt issued by government entities such as a state, city, county, or agency of the government. Money raised from the issuance of municipal bonds is used to build hospitals, schools, sewer systems, airports, highways and other projects for the benefit of the public living in the municipality.
Municipal bondholders are lenders to the state or local municipality or government entity. As with other bond securities, the bondholder receives a promise that the issuer will pay a certain amount of coupon interest and return your principal on a defined maturity date. Although many municipal bonds offer bondholders the benefit of tax-free coupon interest, not all do.
Municipal Bonds and Taxation
Many municipal bond issues offer bondholders the benefit of interest that’s exempt from federal taxes. According to The Wall Street Journal, more than half of all outstanding municipal bond issues offer this benefit. In general, most of these issues have a larger amount of bond debt outstanding.
Other municipal bonds offer freedom from state and local taxes. If you’re a resident of New York State, you might want to own a New York State municipal bond issue because your interest is then free from federal and state taxes. If you’re a New York City resident, you might also want a “triple tax free” bond to save on local taxes as applicable.
However, some municipal bonds aren’t free from all taxes. Some of the interest earned on these issues is taxable for federal purposes and tax-free at state and local levels. If you’re a resident of a state without an income tax, such as Alaska, New Hampshire, Florida, Wyoming, Nevada, Washington, South Dakota, Texas, or Tennessee, these municipal bond issues probably won’t interest you. You’re much more likely to look for federally tax-free interest from high credit quality municipal issuers.
Municipal Bonds and Tax Impact
Municipal bonds that are exempt from taxes are naturally popular with investors. Tax-free municipal bonds offer many benefits, such as:
- Competitive current income that’s free from federal taxes (in some instances, it’s also free from state and/or local taxes)
- Predictable income stream (fixed coupon interest payable on specified dates)
- Safety of principal repayment plus (depending on issuer credit rating) safety regarding prompt payment of interest
- Marketability and liquidity in the secondary market if you want to sell before maturity (including making a traditional tax swap to book losses for tax purposes)
- A wide array of issuer choices to mesh with investment objectives, including issuer quality, maturity date, issuer type, bond type, and geographical locale
Municipal Bonds Safety
If you’d like to earn tax-free interest or make an investment in your community, you need to know if the municipality is able to repay the debt and meet future financial obligations. All municipal bond issuers have a “track record” concerning their prior ability to meet principal and interest payments in a timely manner:
- You can read about the municipality’s payment history in the bond issue’s official statement or offering circular. You can also access this information on the Municipal Securities Rulemaking Board Electronic Municipal Market Access portal, also known as “EMMA.”
- Your broker-dealer, bank, financial advisor, and you can find out more about the issuer’s financial condition by performing an Internet search.
- Review your issuer’s credit rating from Moody’s, Standard & Poor’s, or Fitch Ratings. Not all issues are rated.
- Other issues are followed by regional banks and dealer firms.
Typically, investment quality bonds (rated “BBB” or better by S&P and Fitch, or “Baa” or better by Moody’s) are considered appropriate for investors who desire capital preservation plus income.
According to Fitch Ratings, municipal borrowers are more likely to repay principal in a timely fashion than corporate borrowers. A fast way to assess the municipality’s credit quality is the “general obligation” or “GO” credit.
Taxable Municipal Bonds
In some cases, a municipal or government issue might sell taxable securities because the U.S. government doesn’t want to subsidize financing of some activities. Usually, a decision like this means the U.S. government believes the bond issue won’t offer enough or significant benefits to members of the general public.
The growth of the taxable municipal market continues to increase. The market grew to more than USD 134 billion over the past five years.
Investors tend to lend to municipal projects they support. Some examples of taxable muni bond issues might include replenishment of the local government’s currently underfunded pension, local sporting facilities, refunding a refunded bond issue, or money needed to support an investor-led housing project.
Since these municipal issues are unlikely to offer bondholders the benefit of tax-free income, the municipal issuer must offer a higher coupon rate. In many instances, these bond issues offer rates that are competitive with corporate debt or U.S. government agency paper.
Advantages of Municipal Bonds
This short municipal bond primer can help you choose the right muni bond investments for your portfolio. Most investors lend money to municipal borrowers because they want tax-exempt income. In most cases, your municipal bond investments will yield interest that’s free from federal and/or state and/or local taxes. In addition to all 50 states of the United States, U.S. possessions may also issue municipal bonds that are free from federal, state, and local income taxes. Puerto Rico’s bonds remain very popular with investors for that reason.
To calculate the advantages of municipal bonds in your tax bracket, let’s look at an example:
- You’re in the 33 percent tax bracket this year, file jointly with a spouse, and have USD 210,000 in taxable income. If you’ve got USD 20,000 to invest and you’re comparing a muni bond investment that yields 5 percent and a taxable corporate issue that yields 7 percent, which investment offers the best return?
- If you invest in the municipal bond, you earn USD 1,000 per year in interest (USD 20,000 x 0.05) and you won’t owe any taxes. If you invest in a taxable corporate bond, you actually earn less after taxes are deducted (an equivalent 4.7 percent yield).
- The additional advantage is a subtle one. Investing in a state or local municipal bond issue can be a way to give back to your community while earning a competitive rate of return for your portfolio.