Tax-free investing with municipal bonds

E*TRADE Capital Management

08/24/17

An investment in the community may bring steady income, tax advantages

The roads we drive. The schools we attend. The hospitals we go to when we’re sick. Many institutions woven into the fabric of daily life were made possible by municipal bond issuance. For investors, municipal bonds can provide similar comforts of the familiar, in the form of capital preservation and dependable, typically tax-exempt income.

As with any type of investment, it is important to understand the fundamentals before allocating capital, including the risks involved and the investing strategies that can be deployed. The following outlines the main tenets of municipal bonds and offers considerations for investors as they investigate whether holding these bonds could be appropriate for their financial goals.

Know the municipal bond basics

Municipal bonds, commonly referred to as munis, are debt obligations. In exchange for purchasing the bond, the buyer receives interest payments, typically semiannually, over a set period. At the end of that period, the bond reaches maturity and the full amount of the buyer’s original investment, or the principal, is returned.

States, cities, and other public entities issue debt to fund projects for essential infrastructure and to enhance the quality of public life. Many projects are construction-related, anything from a police station, to a new bridge, to a building at a public university. Municipal debt in the United States dates back to 1812, when New York City issued the country’s first official muni to help finance the construction of a canal. Revenue from muni bond issuance can also be used to fund a government entity’s daily operational costs, including employee salaries and utility bills.

There are two main types of muni bonds: general obligation bonds and revenue bonds.

  • General obligation (GO) bonds are backed by the full faith and credit of the issuing government. Repayment typically occurs with funds generated from taxes. If necessary, the issuer can increase taxes, whether on income, sales, or property, to generate enough revenue to pay the interest due and the principal upon maturity. That taxing authority leads many to consider GO bonds safer investments than their main counterpart, revenue bonds.

  • Revenue bonds finance projects that pay off the bonds with revenue generated from the project. A transportation authority might issue a municipal bond to fund the construction of a toll road and use money from the tolls to repay investors. If repayment proves difficult, the transportation authority could increase toll prices to drive revenue. However, the risk is that the amount of revenue generated from the tolls fluctuates based on market conditions. In theory, drivers could seek alternate routes or another mode of transportation if toll prices increase beyond their willingness to pay.

Notably, interest received from munis is generally exempt from federal and, in many cases, state, and local income taxes, assuming the investor purchases the bonds in his or her home state. Consequently, munis are often viewed as a tax-advantaged strategy for most investors. However, investors subject to the alternative minimum tax (AMT), which the federal government imposes on wealthy individuals and corporations to ensure they pay a fair-share equivalent of federal income taxes, may have to include, among other preference items, interest income from munis.

Understand the risks to investment

No investment is completely risk-free, and municipal bonds are no exception. They are, however, widely viewed as conservative investments and safer than corporate bonds. The tradeoff is that interest rates and yields are typically lower for muni bonds by comparison.

In recent years, more in-depth and critical risk analysis of a muni bond investment has become prudent, in part due to the fallout from the financial crisis in 2008. Previously, many municipal bonds were backed by insurance, removing the latent risk of an issuer failing to meet its financial obligations, but that has changed with insurance availability now more limited.

Federal securities law requires brokerages and banks that sell municipal bonds to make financial information and disclosures available to help investors assess the creditworthiness of a bond. The credit rating agencies can help inform investment decisions as well.

Fitch Ratings and Standard & Poor’s use rating scales ranging from AAA, for likely to meet financial obligations, to D for default. In between, the agencies assign specific criteria to individual letter-based ratings. A BBB- rating or higher is considered investment grade, or representative of minimal investment risk. Moody’s Investor Service has Aaa as its highest rating and C the lowest. In between, Moody’s adds number rankings (1–3) to its grades, where 1 means the issuer is on the higher end of its category and 3 is the low end. For Moody’s, a Baa3 rating or higher is considered investment grade.

Investors are wise to consider all risks with any investment, including those for municipal bonds. General risks associated with munis are highlighted below:

 

  • Credit risk: The issuer could fail to fulfill its payments obligations, whether in making scheduled interest payments or repaying the principal to the bondholder upon maturity.

  • Interest rate risk: Market conditions can affect price. Newly issued bonds will pay a lower yield than existing issues when interest rates decrease, which makes the older bonds more attractive. On the other side, newly issued bonds will pay a higher yield than existing issues if interest rates increase. Market conditions will also dictate gain or loss if an investor decides to sell prior to maturity.

  • Inflation risk: Investors receiving a fixed interest rate see their buying power decrease when prices rise. Inflation can also cause interest rates to rise, which lowers the market value for existing bonds.

  • Liquidity risk: Many investors purchase munis to hold them to maturity, rather than trade them. As a result, the market for a particular bond may not be as liquid for those investors that want to buy or sell in the market prior to maturity.

  • Call risk: Call provisions allow the issuer to redeem the bond prior to the maturity date. Typically, an issuer will call a bond when interest rates drop, and then reissue the bond at a lower rate. In the process, investors could lose out on interest income.

  • Political risk: The attractiveness of muni bonds is directly tied to tax rates, so changes in the tax code can affect the market. In addition, there is always risk that legislation could change the tax-free nature of the income generated by munis.

Outline an investment strategy

Short-term muni bond investment strategies typically have the shortest duration targets and the lowest interest rate risk. They are not an alternative to cash, but can offer higher interest rates than cash if investors are willing to assume some risk. Intermediate strategies are generally the core bond position offering a balance between higher yields in exchange for more interest rate risk. Long-term strategies have the most interest rate risk and may be appropriate for investors seeking to match a long-term liability or those requiring a higher fixed payout over a longer time period (e.g., a 30-year retirement).

In a passive strategy, the simplest approach to municipal bond investing, the goal would be to find a bond with an attractive yield, hold it, and collect the scheduled interest payments and the principal upon maturity. Investors could also construct a bond ladder to increase diversification and mitigate credit risk by purchasing bonds with different interest rates and maturity dates. As each bond matures, the principal from the bond could be reinvested into a new bond.

In an active approach, investors would look to buy and sell the bonds prior to maturity in an attempt to realize a greater total return, which could bring capital gains and thus tax considerations into play. 

Remember the importance of diversification

Default scenarios are rare, but they do occur. In May 2017, for example, Puerto Rico announced its intentions to restructure a significant portion of the $70 billion in municipal debt it owes after failing to reach an agreement with bondholders. The move represents the largest bankruptcy-type scenario in U.S. municipal bond market history. For context, Detroit’s 2013 bankruptcy was the previous record at $18 million.

A lack of portfolio diversification increases an investor’s risk to such default events, but there are ways to mitigate that risk:

  • Spread it out. Investors could spread their capital across several different individual municipal bonds. To note, though, is that tracking the individual bonds and the broader market would likely require significant time, and a certain level of expertise. Not all states are created equal in terms of the landscape for municipal bond investing and many have different challenges that investors need to consider. For example, one state may have more pension liabilities than another, thus increasing the possibility of the state diverting cash flows away from municipal debt service.

  • Consider going national. Investors could seek the relative ease and comfort of a national muni bond fund. Investing in a fund offers exposure to a greater swath of bonds, in different locales. A bond fund has similar characteristics to a stock mutual fund, with diversification the fund’s main attribute. Instead of individual equities or sector concentrations, the fund spreads assets across short-, medium-, and long-term bonds.

Where munis can fit in a portfolio

From a portfolio perspective, municipal bonds can serve as the core of an income strategy, or in a risk-reduction capacity in an equity-heavy portfolio. When deciding whether municipal bond exposure is prudent, a simple formula can help investors determine how a muni’s tax-equivalent yield compares to a taxable credit:

  • Taxable-equivalent yield = muni bond yield/(1 – income tax rate)

Simply, the tax-equivalent yield is the pretax yield that a taxable bond needs to have for its yield to be equal to that of a tax-free municipal bond. The calculation is especially useful when investors considering an investment in municipal bonds know if their income will breach one of the seven marginal tax brackets in the U.S. (10%, 15%, 25%, 28%, 33%, 35%, and 39.6%). For example:

  • An investor in the 35% tax bracket can calculate the tax-equivalent yield for a tax-free bond yielding, say, 4.25%:

Taxable-equivalent yield = 0.0425/(1 – 0.35)

The calculation shows the investor that a municipal bond yielding 4.25% is equivalent to a taxable bond with a yield of 6.54%. With this information, an investment in the muni bond with the tax-equivalent 6.54% yield would be a better investment than a taxable bond yielding, say, 5.25%.

Important to remember as investors lay out a roadmap to incorporate munis in their portfolio, though, is that tax implications can vary from state to state. A New York resident would not pay income tax on a state-issued muni bond, but would have to report income on a bond from Massachusetts. Some investors, notably residents of Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming, would view an out-of-state purchase differently, as they are not subject to state income taxes, meaning there would be no tax break for them. However, investors can use the same formula to find out how an in-state bond, on which no taxes would be paid, compares to an out-of-state bond.  

What to consider

An investment in a municipal bond is an investment in the community at large. Munis offer investors the opportunity to help improve the quality of life around them, whether by building a new school for a growing town or helping to renovate a hospital to incorporate the latest medical technology. Beyond the civic benefits, munis can be a good strategy for investors interested in preserving their capital while generating tax-free income.

However, it is important to remember that while widely viewed as conservative investments, munis are subject to risks and various market forces at play from state to state. They are best implemented into a diversified portfolio that accounts for the investor’s financial goals, time horizon, and risk tolerance.