If a friend asks you, “Are tax-exempt municipal bonds a better investment than taxable bonds?” The correct answer depends on a host of factors specific to a person’s personal situation.
The most important of these concerns the size of your tax bill. If you’re in the 35% tax bracket and live in a state with relatively high tax rates, investing in municipal bonds (munis, for short) is likely to be a better option than taxable bonds. Alternatively, if your income is in the 12% tax bracket, you may want to avoid municipal bonds.
Key points to remember
- In general, tax-exempt municipal bonds (munis) are more attractive to those in higher tax brackets.
- To compare municipal bonds to taxable bonds, you need to determine the equivalent tax yield of the muni.
- Although CDs carry less risk, municipal bonds have tended to outperform them.
How to Compare Municipal and Taxable Bonds
While your tax bracket can provide a rule of thumb when looking at the munis as a whole, you need to take a closer look at individual investment opportunities. Specifically, you need to compare the muni’s yield to that of a comparable taxable bond in determining its equivalent tax yield. Also known as the “after-tax” yield, the tax-equivalent yield takes into account your current tax rate to determine whether an investment in a municipal bond is equivalent to a corresponding investment in a given taxable bond.
Fortunately, there is a formula for this. He is:
Tax − Equivalent return=(1 − Marginal tax rate)Tax − exempt return
Putting this formula into practice, let’s say you are considering a tax-free muni with a 6% return and your marginal tax bracket is 35%. You would enter the numbers as follows:
Tax − Equivalent return=(1 − .35)6
In this case, your equivalent tax yield would be 9.23%. This means that while equivalent taxable debt instruments offer yields in the 7-8% range, your municipal bond with a 6% yield offers a better yield (even if its nominal yield seems lower).
Now let’s say you are in the 12% tax bracket. The equivalent tax yield would be 6.8% (6 ÷ [1-.12]). In this situation, a municipal bond with a yield of 6% would not present a better investment opportunity than taxable bonds with a yield of 7% or more.
Typically, after-tax returns from municipal bonds exceed those from taxable bonds for anyone with a marginal tax rate of 24% or more.
Municipal Bonds vs. Corporate Bonds
Of course, the return is not everything. Investors should also consider the risk of default. Historically, municipal bonds have had low default rates. According to the Municipal Securities Rulemaking Board (MSRB), the 10-year average cumulative default rate for investment-grade municipal bonds through 2016 totaled just 0.18%, compared to 1.74% for corporate bonds. .
Municipal bonds come in two forms: general bonds (GO) and revenue bonds. Both are tax exempt. Although the latter is much more common, the former is much safer. GO bonds use taxes (primarily property taxes) to pay bondholders’ interest and eventually repay their principal. Revenue bonds rely on revenue generated by a project to repay bondholders, which means that performance is partly dependent on economic conditions, which makes them riskier.
Municipal Bonds vs. CDs
Now that we’ve seen how munis compare to taxable bonds, such as corporate bonds, let’s take a look at how munis compare to certificates of deposit (CDs). Although CDs may seem like a better option because they are FDIC insured and therefore pose virtually no risk, they do have drawbacks. One downside is that when interest rates fall, CDs struggle to outpace inflation. Therefore, when we are heading into a deflationary environment, sitting in cash is a more viable option because your money will go further. Of course, when you’re locked into a CD, you get some interest in the meantime, which is a good thing. However, municipal bonds have historically outperformed CDs by a wide margin.
The amount invested in municipal funds in 2019, a record, according to MunicipalBonds.com
Your exposure to tax-exempt municipal bonds should depend on your tax bracket, investment goals and location. If you live in a high-income state, locally issued munis will be triple tax-exempt—that is, exempt from not only federal taxes, but also state and city/county taxes.Ideally, municipal bonds should be part of a well-diversified portfolio that could also include domestic and international stocks, real estate, mutual funds and exchange-traded funds (ETFs), and even other securities debt, such as US government bonds, Treasury Inflation Protected Securities (TIPS) and corporate bonds.
What is a municipal bond?
Municipal bonds, also known as “muni bonds” or “muni”, are basically loans that investors make to local governments. These investments help to pay for local needs such as road works, bridges or the construction of schools. Municipal bonds are often exempt from most federal, state and local taxes.
How do I determine if I should invest in a municipal bond?
Investors looking to get involved in municipal bonds should consider the rate of return, risk factors and their tax bracket.
Are municipal bonds risky?
Municipal bonds in the form of general bonds (GO) tend to be a low risk investment. In effect, GO bonds use taxes to pay investors. Municipal bonds can also take the form of revenue bonds, which carry a higher risk. Municipal bonds finance local projects and revenue bonds repay investors using the revenue generated by these projects. If something goes wrong with the economic conditions surrounding the project, investors could run out of money.