In this article
- Municipal bonds defined
- How municipals differ from corporate bonds
- The four most common types of municipals
- How municipals benefit your portfolio
Nobody likes to pay taxes. That's why many investors turn to municipal bonds, interest on which is free from federal taxes, and in many cases state and local taxes as well.
Municipal bonds (also known as "munis") are fixed-income investments that, depending on your tax bracket, may be able to provide higher after-tax returns than similar taxable corporate or government issues. In general, the interest paid on municipal issues is exempt from federal income taxes and sometimes state and local income taxes as well.
Municipal Bonds Defined
A municipal bond is an interest-bearing debt obligation issued by a state or local municipality, which may support general government needs or fund a public works project. A municipal bond can also be issued by a legal entity such as a housing authority or a port authority. A variety of projects such as new roads, stadiums, bridges, or hospitals are usually financed through the issuance of municipal bonds. In addition to providing tax-exempt earnings, municipals can be an excellent way to invest in the growth and development of your community.
Municipal Bonds Vs. Corporate Bonds
Municipal bonds are different from corporate bonds in several ways.
Most important, the income they generate is usually exempt from federal income taxes, whereas the income generated by U.S. Government or corporate bonds is not. In addition, if the investor lives in the state that issued the bond, the state income tax may be exempted. Local taxes (if any) may also be exempted.* Because municipal bonds are generally free from federal income taxes, they are referred to as "tax-exempt bonds."
Another way that municipal bonds differ from corporate bonds is how they are retired at maturity. Corporate bonds are usually issued with "term" maturities, but many municipal bonds are issued with "serial" maturities. This means that the bond is issued with several maturity dates. A portion of the principal matures with each maturity date until the entire principal has been paid off.
The interest rate of a serial issue can also be different with each redemption date. As with some corporate bonds, many longer-term municipals may also include "call" provisions. This means that the issuer can choose to retire the entire value of the bond early, on the call date, and would likely do so if prevailing interest rates were lower than the bond's coupon rate.
In addition, corporate bonds are usually issued in $1,000 amounts, but municipal bonds are usually offered in principal amounts of $5,000. Finally, municipal bonds are traded only on the over-the-counter market, whereas some corporate bonds are listed on exchanges.
*If the municipal bond is a "private purpose" bond, the income is taxable unless specifically exempted. Income from some bonds may be taxable under alternative minimum tax rules.
The Four Most Common Types: Understand Their Differences
General Obligation Bonds.
The most common type of municipal bond is called the general obligation (GO) bond. These bonds are not tied to a particular community project, and the issuer of the GO bond is obligated to make interest and principal payments on time, which makes them one of the least risky municipal investments.
Backed by the full faith and credit of the issuing government and its taxing power, GO bonds are considered very low risk and thus offer the lowest yields. These bonds must be approved by voters.
Backed only by the revenue that is expected to be generated by the facility being built and secured only by a specified revenue source such as highway tolls or airport fees. They are considered somewhat riskier than general obligation bonds and thus usually offer higher yields.
Short-term debt issued by governments to meet cash-management needs, budget shortfalls, and the like. Typically they are backed by a bank letter of credit and carry maturities of less than nine months. The yields offered are generally low due to their short maturities.
Private Activity Bonds.
Used to fund private pursuits that qualify under federal law as having a tax-exempt status. They are considered riskier than revenue and general obligation bonds and thus offer higher yields.
Other types of bonds include special tax bonds and industrial revenue bonds, as well as variations on the general obligation bond.
How Municipal Bonds Can Work In Your Portfolio
Municipal bonds usually have a yield several percentage points below the yield on corporate bonds of comparable maturity. This means that a municipal bond can provide comparable after-tax yield as a taxable bond paying a higher interest rate.
If you are in a high tax bracket, the benefits of using municipal bonds in the bond portion of your portfolio could be impressive.
For example, if your income tax rate is 28%, a municipal bond paying 6% interest may actually be a better investment than a taxable bond paying interest at 8.3% (assuming that the municipal bond is free from federal and state income tax). Consult your tax advisor for more information.
Keep Potential Risks In Mind
With many thousands of municipal bond issues outstanding, keeping track of prices for each on a day-to-day basis is beyond the capabilities of news reporting organizations. Consequently, you won't see specific municipal bond prices in a newspaper - you will need to consult a bond dealer if you are interested in a specific bond price. And even though municipal bonds are issued in increments of $5,000, the prices are quoted as if they were $1,000 issues.
As with the prices of other types of bonds, municipal bond prices react to changes in interest rates. Short- to intermediate-term bonds are less vulnerable to changing interest rates than longer-term issues, prices of which tend to fluctuate more as rates change.
Municipal bonds also pose credit risks - as became clear when Orange County filed for bankruptcy in 1994. Other risk variables are specific to municipal bonds, such as the potential for future changes in the tax law.
Some of these risks are lessened by purchasing shares of municipal bond funds, which are inherently diversified. Most municipal bond funds invest in the generally higher-quality, federally tax-free issues of state governments and municipalities. Professional management can save you the hassle of having to research and evaluate the thousands of individual bonds on the market. In addition, lower initial investment requirements help ease accessibility to municipal bonds.**
**Capital gains distributions from the fund may be taxable. In addition, some bond fund holdings may be subject to the federal alternative minimum tax. Investment return and principal value will fluctuate for municipal bond funds. When redeemed, shares may be worth more or less than the original cost.
Calculating The Benefits: The Taxable-Equivalent Yield
Although taxable investments such as long-term Treasury bonds might at first glance seem to provide the most potential for higher returns, more is not always better. To calculate the "taxable-equivalent yield" on a comparable taxable investment, use this formula:
Determining The Taxable Equivalent Of A Fixed-Income Investment
Municipal bond fund yield / (1 - your marginal tax rate) =
taxable-equivalent yield of municipal bond
In this instance, if you are in the 28% federal tax bracket, a taxable investment needs to yield 8.3% to equal the lower, but tax-exempt, return offered by a municipal bond fund that currently yields 6%. If you are investing in a state-specific municipal bond fund, add your state and/or local income tax rates to your federal tax rate in computing the taxable-equivalent yield.
If "munis" still mystify you, or you'd like to better understand how they can work in your portfolio, consult your financial professional
Points To Remember
- A municipal bond is a debt obligation issued by a municipality for funding a public works project.
- The income generated by municipal bonds is often exempt from federal taxes.
- Municipal bonds purchased by residents of the municipality may also be exempt from state and local taxes.
- Municipal bonds are issued with "serial" maturities.
- Municipal bonds are usually offered in principal amounts of $5,000.
- Municipal bonds are traded only on the over-the-counter market.
- In some instances, municipal bonds can provide the same after-tax yield as corporate or Treasury bonds paying a higher interest rate.
- Risks in investing in municipal bonds include credit risk and price fluctuations due to changes in interest or tax rates.
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