Is It A Good Idea To Buy Tax-Free Municipal Bonds?

Municipal bonds, or “munis,” are preferred by investors for two main reasons. These are relatively low-risk investments and are not subject to federal taxes.

While muni bonds should be a part of any well-diversified portfolio, they have certain disadvantages. Stable, income-producing bonds should always be included. Before include muni bonds in their investment strategy, those who are interested in buying them need to take a number of things into account.

Key Aspects

• Federal taxes are not due on the interest you receive on municipal bonds, but there could be state, local, or even a combination of taxes.
• Attention: If you receive Social Security, your bond interest will be taken into account when determining how much of your Social Security income is taxed. The amount you owe can go up as a result.
• Municipal bonds often have an interest rate that is lower than rates for corporate bonds. You must decide which transaction offers the best real return.
• On the plus side, compared to nearly any other investment, highly rated municipal bonds are typically quite safe investments. The default rate is tiny.
• There is interest rate risk, as there is with any bond. If you lock up your money for 10 or 20 years and interest rates increase, you’ll be stuck with a performer that doesn’t deliver.

What Are Municipal Bonds?

A loan to a state, local government, or an organization under their authority is known as a municipal bond. A government or agency may issue bonds to pay for ongoing costs or to carry out a specific public project, like building a bridge.

A muni is an investment in debt, just like any other bond. In essence, the investor borrows a chunk of money to a government or organization in exchange for receiving a consistent stream of interest payments. The investor’s money is returned after a certain amount of time. 

Why Do Investors Buy Bonds?

Bonds are purchased by investors in order to preserve their capital (since they’re getting their money back in the end) and generate a consistent income stream (from interest payments).

In order to counteract the higher risks associated with practically every other sort of investment, particularly stocks, many investors allocate a portion of their total holdings to bonds. The goal of diversity is to achieve this. Potential losses from higher-risk investments are reduced by low-risk ones. Even bonds carry some risk. The possibility of an issuer defaulting on its obligations exists.

By looking at the bond’s rating, investors can determine the risk level of a bond they are contemplating. One of the three bond rating companies—Investors Moody’s Service, S&P Global, or Fitch Ratings—rates every bond sold in the United States. Ratings for bonds are determined by looking at the issuers’ creditworthiness.

How Do Municipal Bonds Differ?

Municipal bonds’ main selling feature is their exemption from federal taxes. In other words, there is no federal tax on the interest payments. Municipal bonds are taxed in some states but not in others. Unsurprisingly, it is complicated. Bond interest is irrelevant because seven states do not have any income taxes at all. Other states don’t tax in-state bonds but do tax out-of-state bonds in some circumstances.

Before making a decision, consider municipal bonds carefully and weigh them against alternative options for investing your money for a number of reasons:

• Municipal bonds that are tax-free are not always completely tax-free. As said, state income taxes can apply to the interest. Your muni bond interest will be included in calculating your adjusted gross income if you receive Social Security, which could result in a rise in the amount of your Social Security income that is subject to taxation. Less frequently, the de minimus tax and the alternative minimum tax may have tax ramifications.
• The goal of tax-free municipal bonds, unless you simply dislike paying taxes, is to increase your overall rate of return on investment. To reduce your tax liability, be careful not to choose a subpar return on your investment.
• Like any bonds, municipal bonds are subject to interest rate risk. The risk increases with the bond’s term length. You forfeit a better rate if interest rates increase while your bond is still outstanding.

To compare the real return on a muni bond with a corporate bond, use the tax-equivalent-yield formula: Tax Equivalent Yield = Tax-Free Yield / (1 – Tax Rate).

Translation: The muni must have that yield in addition to being exempt from federal taxes in order for it to have the same yield as a corporate bond.

Comparing Real Returns of Muni Bonds Versus Corporate Bonds

At the federal level, bonds used to finance municipal and state government initiatives like buildings and highways are granted tax-exempt status. Also, buyers of bonds from their states or municipalities may not be subject to local or state taxes on the interest. As a result, some municipal matters are triple tax-free. Lower interest yields offset these tax benefits. Ordinarily, the coupon rates on municipal bonds are lower than those on corporate offerings with identical ratings and maturities.

Investors should therefore use the tax-equivalent-yield calculation to evaluate the yields of taxable investment-grade and government bonds when considering munis. The yield that a taxable bond needs to have in order to match or beat a municipal bond’s tax-adjusted yield is known as the tax-equivalent yield (TEY). Tax-Free Yield = Tax Equivalent Yield (1 – Tax Rate). Municipal bonds are often more advantageous for higher-income investors than for those in lower tax categories because they theoretically result in greater tax obligations.

What Is The Interest Rate Risk?

Governments that issue muni bonds in the US run a minimal chance of default. However, investors who intend to sell their bonds on the secondary market should be aware that bonds by their very nature carry interest rate risk.

A long-term investor may even be at risk of losing their initial investment if interest rates decline. Bondholders who sell 30-year issues could not get the full face value of the bond back.

Risk Of Purchasing-Power

Annual inflation in the United States during the past ten years has fluctuated from -0.7% (in 2015) to a projected high of 7%. (in 2021). In all other cases, it was 2.3% or less throughout that time. As a result, a 20-year municipal bond with a 2.5% yield to an investor in the 25% tax bracket, or a 3.3% tax-equivalent yield, would provide annual returns that would exceed inflation until 2021, at which point it would fall short of doing so.

The biggest possible negative to making a long-term bond investment is purchasing-power risk. In the end, you’ll receive your money back, but it might not be worth as much to you as it once did. Investing solely in low-yielding municipal bonds is a safe approach, but it may also mean forgoing gains that outpace inflation and preserve your spending power. Such risk can be mitigated by maintaining a balance between municipal bonds and (relatively riskier) stocks.

Risk Of Default

In all municipal securities rated by Moody’s Investor Service between 1970 and 2018, 0.16% missed payments to investors. Thus, muni bonds are seen as a rather safe investment.

The COVID-19 pandemic, which caused commercial activity to cease and taxable receipts to cease along with it, served as the ultimate test of muni bonds’ resilience. The total default rate increased year over year to just 0.05% of the $3.9 trillion in outstanding municipal bonds.

Call Risk

The investor is exposed to an additional risk when a bond is issued with a callable option. It indicates that the issuer has the option to cancel the transaction, settle the debt, and halt interest payments. The issuer needs that option so it can potentially issue a new bond at a lower interest rate in the event that interest rates decrease significantly.

Municipal bonds are typically callable. Although their investors will receive their money back, they will need to find a new place to put it. They will receive less money from a fresh bond investment.

A tax trap for muni bond investors with a high amount of income from tax-sheltered sources is the alternative minimum tax.

Tax Traps Of Municipal Bond

Tax-free municipal bonds are not always completely tax-free, as was already mentioned. Senior adults seeking a reliable source of income for their retirement needs find bonds particularly alluring.

That makes Social Security income the most typical trap for buyers of municipal bonds. Notwithstanding the fact that muni bond income is not subject to federal income tax, it is included in the investor’s adjusted gross income. The amount of the taxpayer’s Social Security income that is subject to tax can increase with an increase in adjusted gross income.

The alternative minimum tax, which is specifically targeted at taxpayers with significant income from tax-sheltered sources, can also apply to high-income persons.

How to Invest in Tax-Free Municipal Bond Funds?

Bonds can be immediately purchased and sold by an investor using an online brokerage account. They can also be bought from a bank or a full-service brokerage.

A mutual fund or exchange-traded fund that invests in municipal bonds provides an additional choice.

Tax-Free Municipal Bond: What Is the Average Rate of Return?

In late 2021, interest rates were rising, and municipal bond rates were rising along with them.

10-year AAA-rated municipal bonds had a return of 2.60% as of July 10, 2022, down from 2.70% a week earlier. Bonds with a 20-year AAA rating returned 2.90% as opposed to 3.00% the previous week. Bonds with a 30-year AAA rating returned 3.05% as opposed to 3.15% the previous week.

With Municipal Bonds, Is It Possible To Lose Money?

If the issuer defaults, you could lose the money you invested in municipal bonds. Given that defaults on municipal bonds reached 0.05% of the $3.9 trillion in outstanding debt in 2020, a year in which local tax revenues were wiped out by the COVID-19 pandemic, this risk is negligibly small.

If you are compelled to sell muni bonds on the secondary market at the incorrect moment, you could potentially lose money. The total dollar amount of the outstanding interest payments, taking into account the current rates for new issues, will decide the price you pay.

Municipal Bonds: Which States and Cities Have the Best Ones?

Any issuer’s best municipal bonds are rated AAA. They are issued by state and municipal governments all around the country, and one of the major rating agencies has rated these bonds as AAA. A government’s bond ratings decline when it experiences economic difficulties (but it also will pay a better interest rate in order to attract buyers).

Three of the city of Detroit’s general obligation bonds have payments that were due after its bankruptcy in 2013. That means that in that year, it was in charge of three of the seven defaults on muni bonds rated by Moody’s Investors. Since then, the city has been able to turn around its “negative” prognosis, which S&P Global revised to a “stable” outlook as of January 2021. Its current debt was given a BB- rating.

One of the greatest municipal bonds is one with a rating of AAA or very near to it. One of the worst is a bond issued by a municipal government that is on the verge of declaring bankruptcy. Bond mutual funds or exchange-traded funds (ETFs) are options for investors who don’t want to monitor the finances of the state and local governments they invest in. It will be run by someone who is compensated to take care of such things.

Municipal Bonds: Are They Safe?

As long as its issuer does not go bankrupt, a municipal bond—or any bond, for that matter—is safe. Thankfully, the American bond market makes that extremely unlikely.

The best kind of defense for an investor in bonds is caution:

• Check the bond rating. Defaults are uncommon, although they do occur. An issuer with a rating of AAA, AA, or A is one that is in good financial standing.
• Compare the municipal bond’s real return to other investment options. Saving money on taxes is always wonderful, but not at the expense of earning a higher return elsewhere for a similar risk, like in premium corporate bonds.

Final Thoughts

For investors looking to generate a steady source of income, particularly throughout their retirement years, municipal or corporate bonds are an excellent solution. As compared to nearly any other option, and particularly when compared to stocks, highly rated bonds are by their by nature extremely safe investments.

Federal taxes are not applied to municipal bonds as claimed. This does not imply that a muni bond’s overall return will be the greatest choice for you. To select the finest municipal, corporate, or combination of the two bonds for you, you must still exercise due diligence. Another option is to invest in a bond ETF or mutual fund and delegate the decision-making to someone else.