Investing in Tax-Free Municipal Bonds

Determining Whether Tax-Free Munis Are Right for Your Portfolio

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Investing in tax-free municipal bonds is a great way for investors to enjoy a stream of passive income from the interest coupon while they're helping to finance the infrastructure of the communities in which they reside. You won't just benefit from tax-exempt income. You'll also have a positive impact by helping to finance hospitals, bridges, sewers, schools, and other services.

Municipal bonds will most likely be part of your portfolio at some point if you're a U.S. citizen with a substantial net worth. It's better to familiarize yourself with them early so you can grow more comfortable with their pros and cons by the time you begin writing checks to buy them.

Key Takeaways

  • Municipal bonds are sold by local governments and states to raise money to meet their budget needs.
  • Municipal bonds are effectively loans made to local governments because they pay interest when you cash them in.
  • You don’t have to pay federal income tax on any interest you earn. Some bonds are exempt from taxation at the state level as well.
  • Interest is often less than you would receive from a corporate bond. But you might come out ahead on an after-tax basis.

What Are Tax-Free Municipal Bonds?

Municipal bonds, or munis as they are sometimes known, are debt securities. They're issued by cities, counties, and states to help fund regular operations and special projects, such as a new school or road. You're giving the government a loan when you buy a bond. It promises to repay your principal plus interest. The interest is often paid semiannually.

These bonds are exempt from federal income tax. They may be exempt from state or local tax, too, if you live in the state where they were issued.

Types of Municipal Bonds

General obligation municipal bonds, or GOs for short, and revenue bonds are two types of municipal bonds. General obligation bonds are backed by the "full faith and credit" of the issuing government. This means that the municipalities that issued them can levy taxes to pay you back plus interest. These bonds are used to pay for projects such as schools and sewer systems. 

Revenue munis aren't backed by a government's taxing power. With these types of munis, there's a risk that investors won't have any recourse if the revenue stream dries up.

Tax Advantages of Municipal Bonds

The appeal of municipal bonds is the tax treatment that rewards you for investing in society. The federal government exempts these securities from federal taxes. You won't have to pay state taxes, either, if you live in the state that issued the municipal bond.

Who Should Buy Tax-Free Municipal Bonds?

Tax-free municipal bonds can be very nice holdings for the right investor, such as high earners in states such as California where tax rates on those with high incomes are the highest in the nation. It's possible for a tax-free municipal bond to yield more on an after-tax basis despite appearing to yield much less than corporate bonds. Determine the taxable equivalent yield to find out if this is the case.

Understanding Taxable Equivalent Yield

You'll have to find a way to equalize the two yields in order to compare them when you're deciding between corporate or municipal bonds. You can do this using taxable equivalent yield. The formula for taxable equivalent yield on municipal bonds is simple:

Tax Exempt Yield ÷ (1 - highest tax rate applied to investor earnings)

Imagine that you enjoy income in the low seven figures and you're living in California. You pay 37% on your top dollars at the federal level, and 13.3% at the state level. But federal taxes can be deducted from the calculation of state taxes, so you'd really only have to pay that 13.3% state tax on 63% of your pre-tax earnings, resulting in an effective 4.92% tax on top of the 37% you pay to the IRS.

This means you would use 41.93% for the variable in the taxable equivalent yield calculation. 

Example of Calculating After-Tax Bond Income

Say you're looking at a tax-free municipal bond for Riverside California. It's rated AA by Standard & Poor (S&P) and Aa2 by Moody's. It matures on August 1, 2032, but it's callable, so the yield to maturity of 2.986% is higher than the yield to worst, which is 2.688%. 

Assume that the yield to worst actually comes to fruition. Go with the 2.688% rate. How much would a corporate bond need to yield to provide you with that same after-tax income? Take the taxable equivalent yield formula and plug in what we know:

  • Step 1: 2.688 ÷ (1 - 0.4193)
  • Step 2: 2.688 ÷ 0.5807
  • Answer: 4.63%

You'd need corporate bonds of comparable quality maturing in August of 2032 to pay you 4.63% just to break even with the tax-free municipal bond you're considering, to end up with the exact same amount of after-tax income.

The only comparable bonds are rated AA+ by S&P and A1 by Moody's for General Electric Capital maturing on Dec. 15, 2032, with a yield to maturity of 3.432%. They're non-callable so there is no yield to worst.

That rate isn't good enough. You wouldn't want to buy taxable corporate bonds under these conditions. Your opportunity cost makes them too unappealing. 

Using Asset Placement to Your Advantage

You can arbitrage the tax code by using a strategy called asset placement. This involves putting the right asset in the right vehicle to maximize benefits and minimize your tax burden.

You wouldn't choose to own tax-free municipal bonds inside of a tax shelter such as a Roth IRA because these assets are already tax-protected. You'd be better off buying the higher-yielding corporate bonds for use in your IRA. Those bonds are exempt from federal and state taxes while within the protective confines of that special account. 

Non-profit organizations, charitable institutions, and certain pools of capital, such as endowment funds for higher education, often have little use for tax-free municipal bonds. They're almost always going to be able to find a better deal elsewhere.

Your taxable brokerage account would be a good place to put tax-free municipal bonds in order to take advantage of the tax exemptions.

How To Choose Which Bonds To Invest In

It can be tough to find information concerning municipal bond issues. You would have to invest a good amount of time and effort to assess the quality of a particular bond. This may only seem justifiable if you're investing hundreds of thousands of dollars, but 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. This saves the municipality money by lowering the interest rate and yield.

Analysts at the bond rating agency spend time pinning down the quality and safety of the municipal bond issue. They look at things like the interest coverage ratio to figure out whether a bond should be investment grade. Some municipal bonds are not rated. You may think about passing entirely in this case, or you may be more exacting in looking for a margin of safety if you really want to support the particular bond issue.

Gauging the Safety of Your Tax-Free Bonds

Benjamin Graham, the father of value investing, has some suggestions for gauging the safety of your tax-free municipal bonds in his book "Security Analysis." You're 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 who is responsible for servicing the interest payments. Who is responsible for the future principal maturity of the bonds? What are the underlying economics of the issuer, both in capacity and willingness to make good on its promises?

The Bottom Line

You also have to think about the things you would consider with other types of fixed-income securities. You'll be able to reduce your risk if you have cash flow timing in mind, or if you're planning a long-term investment. You'll increase your effective yield by building a municipal bond ladder. You'll want to think about your inflation risk, too.

Keep an eye on the condition of the bond issuer as well. Look at how the fortunes of Detroit have changed over time. Be sure that you won't need to sell a bond before problems become too far gone to correct, and your principal is at risk. 

Article Sources

  1. U.S. Securities and Exchange Commission. "Investor Bulletin. Municipal Bonds: Understanding Credit Risk," Page 1.

  2. Merrill. "Earn Tax-Free Income With Municipal Bonds."

  3. Tax Foundation. "Taxes in California."

  4. IRS. "IRS Provides Tax Inflation Adjustments for Tax Year 2022."

  5. Benjamin Graham and David Dodd. "Security Analysis: Sixth Edition," Page 177. McGraw-Hill Education, 2008.