Investing in Tax-Free Municipal Bonds

Determining if Tax-Free Munis are Right for Your Portfolio

Tax-Free Municipal Bonds
When you invest in tax-free municipal bonds, you are quite literally helping build society; constructing schools, roads, hospitals, sewers, and other vital infrastructure. In exchange, you are given the chance to avoid both Federal and State taxes on your interest income.. Licensed by Joshua Kennon. Image Credit Sean Pavone / Shutterstock

Investing in tax-free municipal bonds is a time-honored tradition among fixed-income investors who want to enjoy a stream of passive income from the interest coupon, which is exempt from taxation under the right circumstances, while helping to finance the essential infrastructure of the communities in which they reside; investing while having a positive impact by building hospitals, bridges, sewers, schools, and other necessary and desirable services and infrastructure.

 It isn't an exaggeration to say that investing in municipal bonds is doing a service for the civilization.

But municipal bonds, or munis as they are sometimes known, are a unique type of fixed-income security with its own vocabulary, risks, rewards, and opportunities.  I want to take some time to introduce you to tax-free municipal bonds, give you a high-level view of a few of the basics, explain the reason certain things are important, and point you in the direction of further reading if this is an area in which you are interested.  If you are a citizen of the United States, it's highly probable that, sooner or later, municipal bonds will be a part of your portfolio if you have a net worth of any notable size.  It's better to familiarize yourself with them early so you can grow more comfortable with how they work, and some of the pitfalls, by the time you begin writing checks to acquire them.

General Obligation Bonds and Revenue Bonds Are the Two Types of Tax-Free Municipal Bonds You'll Encounter as an Investor

I want to begin by getting into the two types of municipal bonds are you likely to encounter as you begin researching this particular asset class.  The first are called general obligation municipal bonds, or GOs for short, and are backed by the ability of the municipalities that issued them to levy taxes.


  • General obligation bonds are used to pay for projects such as schools and sewer systems.  It seems safe to say the most municipal bond investors consider general obligation bonds to be safer than their revenue bond counterparts; a misconception that you shouldn't believe.
  • Revenue munis, in contrast, are issued by special state or local government sanctioned entities such as a utility company.  The interest is serviced, or paid, by the revenue generated from the business that backs the obligation.  In the case of a water company, bondholders are paid out of the cash generated from customers paying their water bills.

To learn more about this topic, read my article General Obligation Municipal Bonds vs. Revenue Municipal Bonds.

Understanding the Tax Intricacies of Tax-Free Municipal Bonds, Including How to Calculate Taxable Equivalent Yield

At the heart of the appeal of municipal bonds is the tax treatment that rewards investors for investing in society.  Not only does the Federal government exempt these securities from Federal taxes, which can save those in the top tax bracket a total 43.4% tax rate between the highest marginal rate and the special Medicare tax, but if you live in the state that issued the municipal bond, you likely won't have to pay state taxes, either.

 This means, for the right investor in the right circumstances, the right tax-free municipal bonds can be fantastic holdings.  In fact, despite appearing to yield considerably less than corporate bonds, it's possible for a tax-free municipal bond to yield more on an after-tax basis.  To find out if this is the case, you have to equalize the two yields using something known as taxable equivalent yield.

The formula for taxable equivalent yield on municipal bonds is simple.  It is: Tax Exempt Yield ÷ (1 - highest tax rate applied to investor earnings).

An illustration may help.  Imagine that you are a high-earning entrepreneur with income in the low seven-figures living in California so you'd ordinarily have to pay 43.4% at the Federal level, and 13.3% at the state level on the worst-hit of your income.  Since Federal taxes can be deducted from the calculation of state taxes, you'd really only have to pay that 13.3% state tax on 56.6% of your pre-tax earnings, resulting in an effective additional 7.53% tax on top of the 43.4% you pay to the IRS.  This means, all inclusive, you need to use 50.93% for the variable in the taxable equivalent yield calculation.  

You are looking at a tax-free municipal bond for Riverside California rated AA by S&P and Aa2 by Moody's.  It matures on August 1st, 2032 but it is callable so the yield to maturity of 2.986% is higher than the yield-to-worst, which is 2.688%.  In this case, for the sake of conservatism, we'll assume the yield to worse actually comes to fruition and go with the 2.688% rate.  How much would a corporate bond need to yield to provide you that same after-tax income?  

We'd take the taxable equivalent yield formula and plug in what we know:

Step 1: 2.688 ÷ (1 - 0.5093)

Step 2: 2.688 ÷ 0.4907

Answer: 5.48%

That is, to end up with the exact same amount of after-tax income, you'd need corporate bonds of comparable quality maturing in August of 2032 to pay you 5.48% just to break even with the tax-free municipal bond you're considering.  A quick look at the inventory sheets for one major brokerage firm shows the closest you can get to anything in that range at the moment are bonds rated AA+ by S&P and A1 by Moody's for General Electric Capital maturing in on December 15th, 2032.  They have a yield to maturity of 3.432% and are non-callable so there is no yield to worse.  That is not even close.  You'd have no business buying taxable corporate bonds under these conditions.  Your individual opportunity cost makes them too unappealing.  

One way you can arbitrage the tax code is to use a strategy called asset placement.  You would never want to own tax-free municipal bonds inside of tax shelters such as a Roth IRA because you'd be better off buying the higher yielding corporate bonds as they are exempt from Federal and State taxes while within the protective confines of that special account.  Similarly, non-profits organizations, charitable institutions, and certain pools of capital, such as endowment funds for higher education, are similarly going to have little use for tax-free municipal bonds as they're almost always going to be able to find a better deal elsewhere.

Deciding Which Tax-Free Municipal Bonds Are Sufficiently Safe Enough to Justify an Investment

Unless you are willing to invest a significant amount of time and effort to understand the quality of a particular municipal bond, which may only seem justifiable given the dedication it takes if you are investing hundreds of thousands or millions of dollars, there is very little information available concerning individual municipal bond issues.  Fortunately, many municipalities will pay to have bond rating agencies assign ratings to their tax-free municipal bonds in the hope of attracting investors.  More interested investors means more people bidding for the bonds, which lowers the interest rate and yield, saving the municipality money.  The analysts at the bond rating agency spend time determining the quality and safety of the specific municipal bond issue, looking at things like the interest coverage ratio, to determine whether a bond should be investment grade or not.  Some municipal bonds are not rated, in which case the investor may consider passing entirely or, if they are insistent upon supporting the particular bond issue, even more exacting in looking for a margin of safety.

For those of you who want to gauge the safety of your tax-free municipal bonds, the father of value investing, Benjamin Graham, had some suggestions in his treatise Security Analysis.  I cover some of these in an article called Tests of Safety for Tax-Free Municipal Bonds.  For example, at the very least, you are almost always going to want to have minimum population requirements, a history of punctual bond payments, and a diverse underlying economy to support the cash flows.  Above all, you want to know 1.) who is responsible for servicing the interest payments and future principal maturity of the bonds, and 2.) the underlying economics of the issuer, both in capacity and willingness to make good on its promises.

On a related note, one of the biggest dangers you will face, especially with long-dated tax-free municipal bonds, is the risk of inflation.  For my thoughts on this, read Don't Let Inflation Destroy Your Municipal Bond Portfolio.

More Thoughts About Investing in Tax-Free Municipal Bonds

Beyond these considerations, you have to think about the things you would consider with other types of fixed-income securities.  For example, if you have specific cash flow timing needs, or if you have a long enough life expectancy and investment horizon, you're probably going to be able to reduce your risk and increase your effective yield by building a municipal bond ladder.  You're going to want to keep an eye on the condition of the bond issuer - look at how the fortunes of Detroit have changed over time - to make sure prudence doesn't demand you sell a bond before problems become too far gone to correct and your principal is at risk.  

You may also want to check out a fantastic book by a woman named Annette Thau called The Bond  Book.  It was written for those with little or no bond experience and covers virtually everything an investor needs to know. I highly recommend it.

Continue Reading...