Should You Invest In Municipal Bonds?

You may have heard about tax-free bonds and are wondering if you should invest in them. Like many of these questions, the answer begins with, “Maybe...” I’ll explain.

What are tax-free bonds?

They’re aptly named as their interest payments are exempt from federal (and usually state) income taxes. They’re also known as municipal bonds, or “munis” using the Wall Street patois.

These bonds are issued by state and local governments or public agencies that are controlled by these governments. If you own bonds in the state in which you reside, you are also exempt from your state income taxes. (It wouldn’t usually make sense to buy munis that are issued outside of your home state.)

As you might expect, these bonds offer a lower yield because of the tax-free interest income.

To confuse things a bit, bonds issued by the federal government are generally exempt from state income taxes but not from federal taxes. These are not considered municipal bonds.

When does it make sense to invest in them?

To start, for retirement accounts such as a 401K or an IRA, don’t invest in tax-free bonds. There’s no reason to accept a lower yield when you’re not paying taxes on the income.

Munis are also not for institutions such as college endowments and pension funds who do not pay income taxes on their earnings.

These bonds are for investors with high current incomes and a high marginal tax bracket when investing their non-retirement savings. They make even more sense for investors who face a high state income tax rate such as New York and California residents.

You should focus on your after-tax returns from any investment and municipal bonds could offer higher after-tax returns than taxable bonds.

How much less do municipal bonds yield?

It is difficult to exactly compare as the maturities, credit risk, and other terms vary when comparing different bonds but in general, the yield for municipal bonds is ~2/3s of the yield of comparable taxable bonds.

If your marginal tax rate (i.e., the rate you pay on your last dollar of income) for your federal and state income taxes combined is greater than ~33%, then municipal bonds may be a good choice for your taxable funds.

Are municipal bonds safe?

Like most bonds, they’re usually quite safe, until the rare times when they’re not. Traditionally, municipal bonds have been considered a suitable investment for retirees and other conservative investors as the default rates on these bonds is low.

Some semi-famous examples of municipal bond defaults which you may have heard about include Puerto Rico, Detroit, and Jefferson County in Alabama.

What is the best way to invest in municipal bonds?

You can buy individual bonds from a broker but that’s rarely a good idea. Bonds can be quite complicated with multiple issuers, terms, maturities, and other features. Furthermore, they’re not nearly as liquid as buying stocks so if you need to sell them before they mature, the bid-ask trading spread can be wide.

An easier way is to invest in a low-cost mutual fund that has the specific type of bond(s) that you desire. This way, you leave it to the professionals to sort out all the details and you’ll have more liquidity and diversification. Firms like Vanguard and Fidelity have lots of options for municipal bond funds — different states, different terms, money market funds, etc. Investing in one of these funds will be simpler and more cost-effective for you.

PS:  if you want to learn more about the basics of bonds, read my previous note here.