BONDS #8: Municipals

Municipal bonds often seem like special category open only to the very rich. Those lucky few seem to know all sorts of ways to protect their assets from the tax man. They hire specialists who can figure out when they should buy taxable or tax-exempt investments.

But what about the rest of us?!

Folks--this is not rocket science.

What are “munis”?

They are bonds issued by states and local governments, differing by issuer from U.S. treasuries and corporate bonds.

What are the main types?

Some municipal bonds are general obligations “G.O.’s” of states, issued to build public facilities such as schools. These rely on the taxing authority of the state to be repaid.

Others are “revenue bonds”, issued to finance a project, such as a road, which rely on revenue from the toll to repay the loan.

How are they similar to other bonds?

Like other types of bonds, they have coupons and make regular interest payments.

They can even have zero coupons (see the previous article).

They mature at face value on a set date.

They have credit ratings from Moody’s and Standard & Poor’s, so you can keep the default risk at a tolerable level (but not as low as AAA U.S. Treasury bonds).

They can have a guarantee, insurance against default risk, which is frequently added to the bond if the state or municipality does not have a strong credit rating on its own.

They have a yield to maturity, which is the same as the coupon if you pay par (a price of 100). The yield will be higher or lower, depending if you buy the bond at a discount or a premium.

In any case, the yield will be a reflection of the credit quality of the issuer and the maturity of the bond.

How are municipal bonds different?

The income is not subject to federal income tax.

What about state and city taxes?

The income is subject to state and local taxes, if any.

Issuers may exempt their own citizens from local taxes, which makes some municipal bonds triple-tax-free.

This is a good break, but if you have a large part of your investments in municipal bonds, remember that even munis need to be diversified. You should have more than your local area represented in a portfolio.

What’s the downside?

Thought you’d never ask. The yield is lower.

So, when does it make sense to buy a tax-free municipal instead of a taxable corporate bond?

When the amount of income that you keep is greatest.

Let’s try this scenario:

you are looking at AA-rated 10-year bonds

at present, a taxable corporate bond pays 7%

and the triple-tax-free municipal pays 5.25%.

If your tax bracket is 36%,

taxes reduce the corporate’s 7% yield to 4.48% (7 x .64).

You are better off keeping the 5.25% earned on the muni.

What if you are in the 15% tax bracket?

Then, taxes reduce the 7% corporate bond yield to 5.95%.

Better to pay tax and keep 5.95% than get only 5.25%.

At the 28% tax bracket, it is a closer call:

After tax, the 7% corporate bond has a yield of 5.04%, a bit under the 5.25% paid on the tax-free municipal in this example.

At this stage, I would have to think about my income tax levels that are likely in the next few years.

If I were close to retirement, and likely to be in a lower tax bracket soon, I would probably choose the corporate bond.

If I felt fairly safe about my job and prospects for higher income, I would go for the municipal bond.