Municipal bonds in summary:
- State and local governments and agencies issue debt to fund specific projects and general operations.
- Though generally safer than debt issued by companies, municipalities have defaulted in very moderate cases in the past (ie failed to return all of the original investment of the bonds when the loan was due). So, investors face extra risk in these bonds.
- A tax advantage is received by all investors (but generally most beneficial to those in the highest tax brackets) that may make municipal bonds a favorable option compared to Treasuries, money markets, and CDs.
- Due to the tax advantage benefiting the highest earning investors and the still relatively low long-term returns on investment, municipal bonds are not an appropriate investment for young professional investors in the short or long run.
State and local governments (municipalities) also issue debt to fund projects and operations within their jurisdiction. The main attraction to municipal debt is the tax advantage received by high-income investors. Interest received from municipal bonds is exempt from federal income tax, and if the owner lives in the state where the bond is from then they in many cases do not have to pay state income tax either.
Unlike the federal government, however, states have defaulted on their debt in the past so investors do take on the risk of not getting all of their money back. Generally, local governments are forced to operate on a balanced budget, so they can’t spend more money each year than they take in. The federal government, on the other hand, can just issue more and more debt to cover their extra expenses and pay money to debt holders. Municipal debt, however, with a historical default rate well below 0.1 percent (according to rating agency Moody’s), is still seen as safer than debt issued by corporations. The value of municipal bonds can also change with the general rise and fall of interest rates, as seen in our previous calculation with Treasury bonds.
Municipal debt is issued generally for two purposes:
- Tax Backed/General obligation: A local government will issue debt under their own version of the “full faith and credit” pinky swear that Uncle Sam issues for Treasury bonds. But, since the local government is much smaller and has a more focused tax collection source compared to the feds they should be seen as riskier.
- Revenue bond: This type of bond is tied to a specific local project, like a toll road or a sewage project, and the revenues from that project support interest payments to the bondholders. This is a riskier type of municipal bond since if the project tanks and doesn’t have the cash to pay interest or principal (the return of the original money you invested) then the local government is not obligated to step in and pay the balance.
Since municipal bond interest payments (from a semi-annual coupon similar to Treasuries) are not taxed by the federal government they are able to offer lower interest payments than Treasuries in many cases. For example: Say a 10-year treasury bond offers a 3 percent yield. After, for example, a 28 percent federal tax cut this 3 percent coupon is more like 2.16 percent after-tax (.03 x (1 – .28) = .0216). A municipal government bond can thus offer a yield of 2.5 percent and the after-tax return (2.5 percent) would be higher than a Treasury bond, thus making for a more favorable investment. You may also encounter municipal money market funds – which are like money market funds but invest in short-term municipal debt only and offer a similar tax advantage like municipal bonds.
Municipal bonds however are priced to where the benefit is normally to the wealthiest persons in the highest tax brackets. See the table below to find your 2018 marginal tax bracket based on your income level and whether you are married. The marginal tax rate means if you are single and have taxable income (income after deductions and exemptions) of $50,000 then any extra interest income from your bonds will be taxed at 22 percent since it is income between $38,700 and $82,500. The first $9,525 of your income at work is taxed at 10 percent, the income between $9,525 and $38,700 is taxed at 12.0 percent … and you get the point. Marginal tax rates for states vary across each state, but generally run from about 0-8 percent.
Buying and selling municipal bonds before maturity is problematic. They are often quite illiquid and the cost of buying or selling could exceed one years’ income!