Investing in municipal bonds is one way to get a higher yield or interest rate in your portfolio. The interest you earn on municipal bonds or munis is exempt from federal and possibly state taxes. Are municipal bonds right for your portfolio.
Municipal bonds, also called munis can be a good addition to your portfolio. The interest paid on munis can be tax exempt and some have a decent yield that can help you profit depending on your situation.
What Are Municipal Bonds or Munis
Municipal bonds or munis are bonds issued by states, cities and counties to fund a certain project. The project can be something like building a bridge, hospital, highways, schools or any other project that needs to be funded.
The advantage to investing in municipal bonds is that the interest is usually tax free. Sometimes the interest is exempt only from federal taxes and other munis can be exempt from federal, state and local taxes. Municipal bonds are usually favored by those in higher tax brackets, but if the math favors your situation, munis can be a good addition to any portfolio.
The Different Types of Municipal Bonds
- General Obligation Bonds are issued when there are immediate needs for capital.
- Revenue Bonds are municipal bonds that are sold to finance projects like highways and stadiums and can only be repaid from a specified revenue source.
- Public purpose municipal bonds are sold to finance a project such as bridges, highways, schools or other needed infrastructure projects.
- Private purpose municipal bonds will fund some project that will benefit both the public and a private interest. The interests from these bonds are taxable unless specified exempt.
Municipal Bond Risks
Risk, if inflation rises; it can diminish the value of your bond and interest income.
Interest rate risk: When interest rates rise, the price of a bond falls. This is because new bonds issued at the higher interest rate will cause the older, lower interest paying bonds to drop in price. This would not concern a person who is holding the municipal bond to maturity and only interested in the income of the interest payment.
Is the bond callable? This is an important question. A callable bond means that the issuer of the municipal bond can redeem it or call it at any time before maturity. This usually happens when interest rates are dropping and the issuer can buy the old bonds back and reissue new bonds at a lower interest rate.
If your municipal bond is called, this can cause you to lose the interest income you expected over the long term and you also have to then find a new place for your investing dollars and probably at a lower interest or yield. You will know if a municipal bond is callable before buying it. Since this risk is known beforehand, they pay a slightly higher interest rate than a non-callable municipal bond.
Credit Risk and default. What is the credit rating of the issuer of the municipal bond and how much of a risk are they of defaulting on their debt. When investing in municipal bonds like any other bond, you have to know the credit rating of the issuer and the bond. Moody’s and S&P rate these bonds from AAA down to a junk rating of Ba or BB and lower. The lower the rating, the higher the chance for default, but also the higher the interest these munis will pay. A municipal bond defaulting is not very common.
The Tax Advantages of Municipal Bonds or Munis
The interest on most municipal bonds is exempt from federal taxes, except for the private purpose munis. If you buy a municipal bond issued in the state you live in, those munis can be exempt from federal and state taxes and in some cases your local taxes.
Municipal bonds are usually bought for income and not capital appreciation or gains. If you were to sell your municipal bonds for a capital gain, the gain would be taxable.
The main questions are; should you invest in municipal bonds, are they right for your tax situation. Will you make more money after taxes with a regular bond or a tax exempt municipal bond? There is some math you can do to answer this question.
You first need to find the reciprocal of your tax bracket.
Step 1: Start with 100
Step 2: Subtract your tax bracket from 100; this is your reciprocal tax bracket number.
Step 3: Divide the yield of the municipal bond by your reciprocal tax bracket number.
For example, if your tax bracket is 33%, subtract 33 from 100 equals 67. So 67 is your tax bracket reciprocal.
You find a municipal bond that is paying 5%; you divide 5 by 67 which equals 7.46%. This means that for your situation, a municipal bond paying 5% will be the same as a taxable bond that pays 7.46%.
This math works for federal tax exempt munis. Buying a municipal bond that is issued in the state you live in could be exempt from federal, state and possibly local taxes, which in effect could raise the equivalent of the taxable bond yield. You can go to this tax equivalent yield calculator for both federal and state exempt yield comparisons.
The alternative minimum tax (ATM) can change how your tax status and the interest on the municipal bonds you hold are calculated. You should talk to your accountant about this.
Finding Municipal Bonds or Munis to Buy
There are many different munis to choose from, with different yields and credit ratings. If you are not interested in investing in municipal bonds separately or holding them until maturity, you can invest in munis through mutual funds and ETFs. You can also buy a municipal bond ETF for a certain state and if you live in that state you can get the federal and state tax break. Some muni ETFs include:
- PowerShares Insured National Muni Bond (PZA)
- iShares S&P National AMT-Free Muni Bond (MUB)
- SPDR Nuveen Barclays Capital Muni Bond (TFI)
- Market Vectors Intermediate Muni ETF (ITM)
- Market Vectors Long Municipal Index (MLN)
- Market Vectors High-Yield Muni (HYD)
- iShares 2017 S&P AMT-Free Municipal Series (MUAF)
You can also buy municipal bond mutual funds from firms like Fidelity, Vanguard and Nuveen.
Investing in Municipal Bonds Conclusion
Remember to watch fees and expenses since those will take away from your overall return. Current thinking is that interest rates will be rising, it might be better for you to look at short to intermediate term munis. Do the math and you might find municipal bonds would be a profitable addition to your portfolio.
Copyright © August 2011 Sam Montana
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