Municipal bonds, sometimes known as “munis,” are popular among investors for being low-risk investments and not being subjected to federal taxes. There are disadvantages to buying munis, even though reliable, income-producing bonds should have a place in any well-diversified portfolio. Therefore, before including muni bonds in their investment strategy, those interested in buying them need to consider several things.
Knowledge about these bonds
A loan to a state, local government, or an organization under their authority is known as a municipal bond. A government or agency may issue these bonds to pay for ongoing costs or to carry out a specific public project. A muni is an investment in debt, just like any other bond. The investor lends a chunk to a government/public organization in exchange for receiving a consistent stream of interest payments.
Reasons behind the investment
Bond purchases enable investors to preserve their cash while generating a consistent income stream (from interest payments). Investors allocate a portion of their total holdings to bonds to counteract the higher risks associated with practically every other sort of investment. The goal of diversity is to achieve this, investments with low risk serve to offset any losses from investments with higher risk. However, even bonds carry some risk. The possibility of an issuer defaulting on its obligations exists.
By looking at the bond’s rating, investors can determine the risk level of a bond they are contemplating. Three bond rating companies, Moody’s Investors Service, S&P Global, and Fitch Ratings, assign ratings to all bonds sold in the United States. A study of the issuers’ creditworthiness is the foundation for bond ratings.
What sets these bonds apart
Municipal bonds’ main selling feature is their exemption from federal taxes. Municipal bonds are subject to taxation in some states but not all. Unsurprisingly, it is complicated. Bond interest is irrelevant because seven states do not have any income taxes at all. While some jurisdictions tax out-of-state bonds, other governments do not tax in-state bonds. Before making a decision, consider municipal bonds carefully and weigh them against alternative options for investing your money.
Tax-free municipal bonds are only sometimes wholly tax-free. As said, state income taxes can apply to the interest. In addition, your muni bond interest will be included in calculating your adjusted gross income if you receive Social Security, which could result in a rise in your Social Security income subject to taxation. Less frequently, the de-minimus tax and the alternative minimum tax may have tax ramifications.
Tax-free municipal bonds aim to increase your overall rate of return on investment. To reduce your tax liability, be careful not to choose a subpar return on your investment. Like any bonds, municipal bonds are subject to interest rate risk. The risk increases with the bond’s term length. You forfeit a better rate if interest rates rise while your bond remains outstanding.
Actual returns of Muni and Corporate Bonds in comparison
Federal law grants tax-exempt status to bonds that finance local and state projects. Additionally, buyers of bonds from their states or municipalities may not be subject to local or state taxes on the interest. As a result, some municipal matters are triple tax-free. Lower interest yields offset these tax benefits. Ordinarily, the coupon rates on municipal bonds are lower than those on corporate offerings with identical ratings and maturities.
When considering munis, investors should use the tax-equivalent-yield calculation to evaluate the taxable investment-grade and government bonds yields. The yield that a taxable bond needs to have to match or beat a municipal bond’s tax-adjusted yield is known as the tax-equivalent yield (TEY). Tax-Free yield equals 1 – (Tax Rate – Tax Equivalent Yield). Municipal bonds are often more advantageous for higher-income investors as they result in more outstanding tax obligations.
Rate of interest risk
Governments that issue muni bonds in the US run a minimal chance of default. However, investors who intend to sell their bonds on the secondary market should be aware that bonds carry interest rate risk by their very nature. Long-term investors may even risk losing their initial investment if interest rates decline. For example, bondholders who sell 30-year issues may not get the total face value of the bond back.
Risk of purchasing power
Annual inflation in the United States over the previous ten years has varied from a low of 0.7% (in 2015) to a high of 7% (in 2021). In all other cases, it was 2.3% or less. As a result, a 20-year municipal bond with a 2.5% yield to an investor in the 25% tax bracket, or a 3.3% tax-equivalent yield, would provide annual returns that would exceed inflation until 2021, at which point it would fall short of doing so. The expected inflation rate in 2023 is 5%, down from 2022’s 6.5% rate.
A purchasing-power risk is the most significant possible negative to making a long-term bond investment. Ultimately, you’ll receive your money back, but it might be worth less than it once did. Strictly sticking to low-yielding municipal bonds is a safe strategy, but it may also mean forgoing gains that outpace inflation and preserve your spending power. A balance between (relatively riskier) stocks and municipal bonds can reduce that risk.
Default danger
In all municipal securities rated by Moody’s Investor Service between 1970 and 2018, 0.16% missed investor payments. Due to this, investors consider municipal bonds to be a generally safe choice. The COVID-19 outbreak, which caused commercial activities and taxable receipts to cease along with it, served as the ultimate test of muni bonds’ resilience. The total default rate increased year over year to just 0.05% of the $3.9 trillion in outstanding municipal bonds.
Call danger
Investors take on additional risks when buying bonds that include callable options. It indicates that the issuer can cancel the transaction, settle the debt, and halt interest payments. The issuer needs that option to issue a new bond at a lower interest rate if interest rates decrease significantly. Municipal bonds are typically callable. Although their investors will receive their money back, they must find a new place to put it. As a result, they will receive less money from a new bond investment.
Tax traps for municipal bonds
Tax-free municipal bonds are not always wholly tax-free. Senior citizens seeking a reliable source of post-retirement income need to find bonds particularly alluring. That makes Social Security income the most typical trap for buyers of municipal bonds. Although muni bond income is not subject to federal income tax, it is included in the investor’s adjusted gross income. Therefore, the amount of the taxpayer’s Social Security income subject to tax can increase with an increase in adjusted gross income. The alternative minimum tax, which explicitly targets taxpayers with significant income from tax-sheltered sources, can also apply to high-income persons.
How to invest in tax-free municipal bond funds
An investor can buy and sell bonds through an online brokerage account. A full-service brokerage or a bank is the other option for buying them. A mutual or exchange-traded fund that invests in municipal bonds provides an additional choice. By the end of 2021, municipal bond rates were growing, along with interest rates. A 10-year AAA-rated municipal bonds had a return of 2.15% as of April 16, 2023, down from 2.30% a week earlier. Compared to the previous week, a 20-year AAA-rated bond returned 3.00% instead of 3.15%. Bonds with a 30-year AAA rating returned 3.20% as opposed to 3.35% the previous week.
Municipal bonds may cause losses
If the issuer defaults, you could lose the money you invested in municipal bonds. However, considering that COVID destroyed local tax receipts in 2020, defaults on municipal bonds only represented 0.05% of the $3.9 trillion in outstanding debt at that time; this danger is vanishingly tiny. Additionally, muni bonds could cost you money if you sell them at the wrong moment on the secondary market. Considering the current rates for new issues, the total dollar amount of the outstanding interest payments will decide your price.
Which states and municipal bonds are the best?
Muni bonds rated AAA are the best available from any issuer. One of the major rating agencies has rated the bonds that these state and local governments around the country have issued as AAA. When a government experiences financial difficulties, it’s bond ratings decrease (but it will also offer a lower interest rate to entice buyers).
Three of the city of Detroit’s general obligation bonds have payments due after its bankruptcy in 2013. That means that that year, it was in charge of three of the seven defaults on municipal bonds rated by Moody’s Investors. Since then, the city has been able to turn around its “negative” prognosis, which S&P Global revised to a “stable” outlook as of January 2021. Its outstanding debt had a BB+ rating.
One of the most significant municipal bonds is one with a rating of AAA or very near to it. One of the worst kinds of bonds is a local government on the verge of bankruptcy issues. Bond mutual funds or exchange-traded funds (ETFs) are options for investors who want to avoid monitoring the finances of the state and local governments they invest in. It will be run by someone compensated for caring for such things.
The bonds are considered as safe as long as the bond issuer isn’t financially ruined. The best defence for a bond investor is caution. Defaults are uncommon, although they do occur. An issuer with an AAA, AA, or A rating is in good financial standing. Compare the municipal bond’s actual return to other investment options. Of course, saving money on taxes is always wonderful, but not at the expense of earning a higher return elsewhere for a similar risk, like in premium corporate bonds.
For investors looking to generate a steady source of income, particularly throughout their retirement years, municipal or corporate bonds are an excellent solution. Compared to nearly any other option, particularly stocks, highly rated bonds are incredibly safe investments. The tax-free status of municipal bonds is true to its advertising. However, this does not imply that a muni bond’s overall return will be your most excellent choice. You must still exercise due diligence to select the finest municipal, corporate, or combination of the two bonds for you. Another option is to invest in a bond ETF or mutual fund and delegate the decision-making to someone else.