Municipal bonds are issued by a city or other local government, such as counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and hospitals and any other state government entities. Also known as “munis,” municipal bonds are attractive to many investors within taxable accounts, because the interest income is exempt from federal income tax, and in many cases, state and local taxes as well.
Municipal bonds come in the following two varieties: general obligation bonds and revenue bonds. General obligation bonds are issued to raise immediate capital to cover expenses and are supported by the taxing power of the issuer. Revenue bonds, which are issued to fund infrastructure projects or operations, are supported by the income generated by those projects. Sewer, water and transportation operations are among the many revenue bonds. Both general obligations and revenue bonds are tax exempt and carry a low-risk factor, because there is the high likelihood that the issuer will repay the debt.
Generally, municipal bonds are considered safer than corporate bonds with similar safety ratings, as governments are less likely to default. While buying municipal bonds can be considered a conservative investment strategy, they are not risk-free. Ratings agencies, such as Moody’s or Standard & Poor’s issue ratings from ‘Aaa’ or ‘AAA’ for the most creditworthy issuers to ‘Ca’, ‘C’, ‘D’, ‘DDD’, ‘DD’ or ‘D’ for those in default. Bonds rated ‘BBB’, ‘Baa’ or better are generally considered appropriate investments, if an investor is seeking to preserve capital. Henssler Financial recommends buying municipals bonds rated ‘AA’ or better by S&P or ‘Aa2’ or better by Moody’s. Additionally, we recommend the bond issuer has a rating of ‘A’ by S&P or a rating of ‘A2’ by Moody’s. Currently, the state of Georgia is one of few states that carry the triple-A rating from the three rating agencies.
While municipal bonds are not as “safe” as treasury bonds, they offer better tax equivalent yields, when you take the tax-free nature into account. The tax-equivalent yield is commonly used when evaluating municipal bond returns. This is the return that is required on a taxable investment to make it equal to the return on a tax-exempt investment. The tax-equivalent yield depends on an investor’s tax bracket. The higher the individual income tax bracket, the more attractive the tax-free income paid by a municipal bond becomes.
For example, a tax-free yield of 7% is equivalent to a taxable yield of 9.3% for an investor in the 25% tax bracket and to a taxable yield of 10.4% for an investor in the 33% tax bracket.
The formula for taxable equivalent yield is:
R(te) = R(tf)/(1- t)
R(te) = taxable equivalent yield for the investor
R(tf) = return on tax-free investment (usually a municipal bond)
t = investor’s marginal tax rate (federal rate + state rate)
For example, let’s assume a Georgia-based investor John is in a 28% federal tax bracket with Georgia income tax at 6%. He is considering whether to invest in a municipal bond with a 10% interest rate. Using the formula above, we can calculate that, for John, the municipal bond’s taxable equivalent yield is:
R(te) = 0.10 / (1 – (0.28+0.06))
Therefore, a taxable bond would have to yield greater than 15.15% to become more profitable for John than the municipal bond when assets are held in a taxable account.
The tax-free advantage of municipal bonds can make a tremendous difference in an investor’s overall returns, especially if the investor is in a high tax bracket. For example, let’s assume another Georgia-based investor, Laurie, only has a marginal tax rate of 20% with Georgia income tax at 6%. She is considering whether to invest in that same 10% municipal bond. Using the formula above, we can calculate that Laurie’s taxable equivalent yield for the same bond is:
R(te) = 0.10 / (1 – (0.20+0.06)
R(te) = 0.135 = 13.5%
For John, a taxable bond would have to return more than 15.15% to become more favorable than the 10% municipal bond. But because Laurie is in a lower tax bracket, she would only have to earn more than 13.5% from the taxable bond for it to become more favorable to her than the same 10% municipal bond.
While we have made the references to the tax benefits of owning tax-exempt municipal bonds, it should be made clear that municipal bonds and the associated math to figure their tax-equivalent yield only pertain to taxable accounts. For tax-exempt accounts, look for bonds with higher yields.
Investors with assets in retirement accounts are likely to find better yields in corporate bonds. For the aforementioned benefit of lower risk, Henssler Financial ceased buying and recommending corporate bonds for investment during the financial turmoil of 2008 and 2009. Watching highly rated company bonds (like those issued by AIG) fall from the safe ratings of AA by four ratings levels virtually overnight, gave us pause for concern. In the absence of buying corporate bonds, we began buying taxable municipal bonds in retirement accounts. Although there have been historically few taxable municipal issues in the past, a Federal Program aimed at assisting municipalities with funding, called “Build America Bonds,” prompted many municipalities to issue taxable municipal bonds during the past year. The yields on taxable municipal bonds closely match yields on corporate bonds, but as noted earlier, the bonds generally have less risk of default. In cases where taxable municipal bonds are purchased in non-taxable accounts, the stated yield is the actual or “tax-equivalent yield.” No math is necessary.
If your primary investing objective is to preserve your capital, while generating a tax-free income stream, municipal bonds are worth considering. When you buy a municipal bond, you are loaning money to the issuer in exchange for a set number of interest payments over a predetermined period. At the end of that period, the bond reaches its maturity date, and the face amount of your original investment should be returned to you. Since bonds are seldom issued or purchased at face value, known as par, pay attention to the stated yield-to-maturity. If the bond is held to maturity, this yield-to-maturity will not change, as it is based on your purchase price. Even as the bond price fluctuates due to market yield changes, you will achieve the originally stated yield-to-maturity.
Municipal bonds provide an attractive investment for security in any account relative to similarly-rated corporate bonds. They also provide an investment that allows you to manage tax liabilities in taxable accounts, not to mention help fund communities within your home state.
For more information on municipal bonds and whether they can play an important role in your portfolio, contact Henssler Financial at 770-429-9166 or [email protected].