Like all investments, municipal bonds are not appropriate for everyone. Investors in high tax brackets often find them attractive because they generally provide tax advantages. But should you make municipal bonds part of your investment portfolio?
Here are some considerations to help answer that question:
Municipal or "muni" bonds are issued by states, cities, counties and other government entities in order to raise money for projects including roads, bridges, sewer systems and schools. Most municipal bonds make semiannual interest payments.
There are different types of municipal bonds. You can invest in:
Riskier bonds generally offer higher yields (prices adjust accordingly). The safer the bond, the lower the interest rate tends to be.
The municipal bond market is huge. There are many types of municipal bonds for selection, covering various types of projects and needs. The pricing and rating of the bonds fluctuates with the market. Your financial advisor can help you select the proper bond for you.
It is important to evaluate the risks involved before investing. Most bonds have a rating from the major ratings agencies. The higher the rating, the safer the bond is supposed to be. The lower the rating, the less secure the bond is viewed to be.
There are variations on the rating grades of the rating agencies and categories of outlooks — possibly positive, neutral or negative, which you should review to determine how risky the bond is.
One misconception about municipal bonds is that they cannot go into default. While few defaults have occurred historically, it is possible and should be considered.
For many municipal bonds, another risk involves the potential for an issuer to "call" them before the maturity date. This is more likely to happen when interest rates are declining. Check into the call provisions in the bond's Official Statement before investing. Keep in mind that many muni bonds are callable after 10 years.
There is also a liquidity risk with municipal bonds. You may not find an active market, which could prevent you from buying or selling when you want at the price you want. Many investors buy municipal bonds to hold them rather than to trade them, so the market for a particular bond may not be especially liquid and quoted prices for the same bond may differ.
The tax implications of municipal bonds are detailed in the box below. To determine whether a municipal bond portfolio is right for you, you must determine whether the rate of return after taxes is beneficial in your tax bracket. Compare the price of the tax-free bond against taxable bonds to determine if the after-tax return is a suitable choice for you.
Ask your financial adviser to do an analysis to determine if munis are appropriate for you. An analysis can include a review of the yield curve (which shows interest rates for short-, medium- and long-term bonds mapped out on a scale). By reviewing the yield curve for taxable and nontaxable bonds, taking into consideration your tax bracket, you can see if a municipal bond purchase would work for your portfolio. Your advisor can also calculate the tax-equivalent yield, which shows how a tax-free muni compares to a taxable bond in your bracket.
If you determine that municipal bonds would be a good fit, your financial advisor can help determine the right investments for you. They tend to make more sense for investors in higher tax brackets who value the tax benefits.
Another potential benefit: For some investors, municipal bonds provide the satisfaction of helping their state or local governments build and improve their infrastructure. While the tax advantages may be the main reason for investing, the opportunity to enhance their communities is an added bonus.
Interest from municipal bonds is generally exempt from federal taxes. Plus, if you buy a state bond issued by the state where you live, the interest is exempt for state tax purposes.
For example, if you live in state A and buy its municipal bonds, then you do not have to pay federal or state A taxes on the interest. However, if you live in state B and buy state A municipal bonds, you will have to pay state B taxes on the interest of the state A bonds. (You would generally still get the federal tax exemption.)
Capital gains tax: Even if interest is tax exempt, when an investor redeems or sells a muni bond, any capital gain is taxable.
Alternative minimum tax (AMT): Interest from "private activity bonds," which are tax-free for regular tax purposes, are taxable under the AMT rules.
Social Security recipients: Investing in municipal bonds may result in your Social Security benefits being taxed. Taxability of benefits depends on your provisional income, which is calculated by adding:
Your financial advisor and your tax advisor can provide more information in your situation.