Investing in Tax-Free Municipal Bonds

Determining if Tax-Free Munis are Right for Your Portfolio

Tax-Free Municipal Bonds

Sean Pavone / Shutterstock

Investing in tax-free municipal bonds is a great way for investors to enjoy a stream of passive income from the interest coupon while helping to finance the essential infrastructure of the communities in which they reside. These investors not only benefit from tax-exempt income but they also have a positive impact by helping to finance hospitals, bridges, sewers, schools, and other services and infrastructure.

If you are a U.S. citizen with a net worth of any notable size, it's very likely that municipal bonds will part of your portfolio at some point. 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 acquire them.

Key Takeaways

  • Municipal bonds are sold by local governments and states to raise money to meet their budgetary needs.
  • Bonds are effectively loans made to the government because they pay interest when you cash them in.
  • You don’t have to pay federal income tax on any interest earned, and some bonds are exempt from taxation at the state level as well.
  • Interest is usually 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 in addition to special projects, such as a new school or road. By buying a bond, you're giving that government a loan, and it promises to repay your principal plus interest (usually paid semiannually).

Typically, these bonds are exempt from federal income tax. Sometimes, they may be exempt from state or local tax, too—usually when you live in that state or locality.

Types of Municipal Bonds

Two types of municipal bonds you are likely to encounter are called general obligation municipal bonds, or GOs for short, and revenue bonds.

General obligation bonds are backed by the "full faith and credit" of the issuing government, meaning the ability of the municipalities that issued them to levy taxes. They're generally used to pay for projects such as schools and sewer systems. 

Revenue munis, in contrast, are issued for a specific project or source and aren't backed by that government's general taxing power. There's a risk with revenue munis that if the revenue stream dries up, investors won't have any recourse.

Tax Advantages of Municipal Bonds

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, but if you live in the state that issued the municipal bond, you likely won't have to pay state taxes, either.

Who Should Buy Tax-Free Municipal Bonds?

For the right investor, tax-free municipal bonds can be fantastic holdings—especially for high earners in states such as California, where tax rates on those high incomes are among the highest in the nation and where the tax savings would be appreciable.

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 figure that out, you'll need to calculate the taxable equivalent yield.

Understanding Taxable Equivalent Yield

Deciding between corporate or municipal bonds means you need to find a way to equalize the two yields in order to compare them. You can do this using something known as 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).

To understand what this looks like, consider an example. Imagine that you are a high-earning entrepreneur with income in the low seven figures living in California. Ordinarily, you would have to pay 37% at the federal level and 13.3% at the state level on the worst-hit portion 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 (which includes a 1% "millionaire tax" ) on 63% of your pre-tax earnings, resulting in an effective additional 4.92% tax on top of the 37% you pay to the IRS. This means, all-inclusive, you need to use 41.93% for the variable in the taxable equivalent yield calculation. 

Example of Calculating After-Tax Bond Income

Say you are looking at a tax-free municipal bond for Riverside California rated AA by Standard & Poor (S&P) and Aa2 by Moody's. It matures on Aug. 1, 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 worst 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 - 0.4193)
  • Step 2: 2.688 ÷ 0.5807
  • Answer: 4.63%

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 4.63% just to break even with the tax-free municipal bond you're considering. 

Now consider that 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 are non-callable so there is no yield to worse.

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

One way you can arbitrage the tax code is to use a strategy called asset placement, which is putting the right asset in the right vehicle to maximize benefits and minimize your tax burden.

For example, you wouldn't choose to own tax-free municipal bonds inside of a tax shelter such as a Roth IRA, because those assets are already tax-protected. You'd be better off buying the higher-yielding corporate bonds for use in your IRA, as 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, are likely 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.

On the other hand, 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 Bond to Invest In

It can be tough to find adequate information concerning individual municipal bond issues. Therefore, you would need to invest a significant amount of time and effort to understand the quality of a particular municipal bond, which may only seem justifiable if you are investing hundreds of thousands or millions of dollars.

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.

Gauging the Safety of Your Tax-Free Bonds

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 book "Security Analysis." For example, 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?
  2. What are the underlying economics of the issuer, both in capacity and willingness to make good on its promises?

Further Considerations

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

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

For further reading, check out "The Bond Book" by Annette Thau. It was written for those with little or no bond experience and covers virtually everything an investor needs to know.