Investing in Municipal Bonds
You may want to consider municipal bonds as part of the fixed income portion of your
investment portfolio. States, cities and other local authorities issue municipal bonds
(munis) to fund their general activities or to fund a specific project. Their interest is
exempt from federal income tax and may be free from state tax if the bonds are from
your home state.
There are three issues to consider for municipal bonds:
Does the tax-free nature of the interest justify the usually lower rate?
What are the risks?
How can they be purchased?
Tax Implications
It is only logical that the interest rates on municipal bonds are generally lower than
those of similar taxable bonds. To determine if munis make sense, you need to
compare the after-tax yield of a similar taxable bond with the yield of the tax-free bond.
If the tax-free bond yield is higher, then you may want to consider it. Here is a chart to
help with the comparison.
Tax free yield Equivalent taxable yield in these tax brackets
15% 25% 28% 33% 35%
3.0% 3.5 4.0 4.2 4.5 4.6
3.5% 4.1 4.7 4.9 5.3 5.4
4.0% 4.7 5.3 5.6 6.0 6.2
4.5% 5.3 6.0 6.3 6.8 6.9
5.0% 5.9 6.7 6.9 7.5 7.7
5.5% 6.5 7.3 7.6 8.3 8.5
The tax brackets are those in effect in 2011.
According to the chart, a tax-exempt bond yielding 4.0% has an equivalent after-tax
yield of 6.0% for someone in the 33% tax bracket. For that person, a taxable bond
yielding more than 6.0% will produce a better after tax return. Taking time to understand
how the tax laws apply to your financial situation will enable you to make more informed
decisions.
Risks
Like any investment, there are risks with owning municipal bonds. There can be
defaults if the issuer does not pay the interest during the term of the bond or repay the
principal on maturity. To guard against default, you should probably stay with the bonds
that are highly rated by professional rating agencies like Moody’s and Standard &
Poors.
In addition, the value of the bonds can change as interest rates change. When interest
rates rise, the market value of bonds (including municipal bonds) falls. The opposite
holds true as well. If rates fall, the value will rise. The amount by which the value drops
(or rises) is largely dependent on the maturity length of the bond. The longer the time
until maturity, the greater the change in value as rates change.
Buying Municipal Bonds
Along with buying individual municipal bonds, you may want to consider investing in a
municipal bond mutual fund. Most stockbrokers will want to sell at least $5000 of a
single issue. With a municipal bond mutual fund, the minimum investment may be
smaller and you get the services of the portfolio manager who selects and monitors the
portfolio of bonds.
Summary
Municipal bonds have the usual risks of any fixed income investment. However, if your
tax bracket is high enough and you stay with high quality bonds they can be an
attractive addition to your portfolio.