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Chapter 12 Municipal Bonds—The Tax-Free Choice
“You work hard all your life to reach a high tax bracket,and then the government goes and lowers it on you.”
Do I Need to Read This Chapter?
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• Do I want,or need,tax-exempt income? • Am I prepared to invest a fair amount of money,usually a minimum of $5,000? • Do I understand the problems of investing in municipal bonds while collecting social security benefits? • How can I eliminate the risk of buying municipal bonds? • Do I know how to find the best bond values?
With proposals of new tax reform and the changing of some of the tax code in 2010,the desire for untaxed income has become stronger than ever.Since tax-exempt bonds yield about 85 percent of comparable taxable instruments,the investor in a high tax bracket has a chance to lock in excellent returns.
How Do Municipal Bonds Work?
Today,few local or state governments have on hand the vast sums of money needed to build schools,roads,water and sewer facilities,and other public works.Some towns,cities,and counties are finding it difficult to meet their daily operating expenses.But these social needs won’t just disappear.In order to meet these expenses,communities borrow money by issuing vehicles known as municipal bonds (munis),which are tax free.More than 40,000 different governmental units and agencies are currently issuing municipal bonds.They include states,cities,towns,counties,and such agencies as highway departments and housing authorities.
What Types of Municipal Bonds Are Available?
Among the more popular varieties of municipal bonds available are the following: 1. General obligation (GO) bonds.These are backed by the full faith and credit of the issuing agency.Interest payments on GO bonds are supported by the taxing authority of the state or city government and are generally considered the safest form of municipal bonds. 2. Revenue bonds.These are usually issued by a government agency or commission that has been charged with operating a self-supporting project such as a highway or bridge.The money raised through the sale of revenue bonds goes to finance the project,and the income realized from the completed project (tolls,for example) is used to pay the interest and principal on the bonds.
Revenue bonds pay a slightly higher yield than GO bonds.You can guess why—there’s more risk.If the project being financed by the bond should earn insufficient income,bondholders may be the ones left holding the bag. The taxpayers of the community are not responsible.Seems unfair? The fact is that if revenue bonds default,the courts are reluctant to auction off the bankrupt assets so that the bonds can be repaid.Municipal assets are viewed as being vital for the public welfare;thus their sale could place the community in jeopardy.
What Are the Advantages and Disadvantages of Municipal Bonds?
The advantages of municipal bonds are as follows: 1. Tax exemption.For the investor,the most important advantage of municipal bonds is the fact that they earn income that is tax free at the federal level.If you live in the state in which the bonds are issued,the bonds are usually free from state and local taxes as well. 2. Safety.Municipal bonds have historically been a very safe form of investment since states and cities,with their power of taxation,have normally been able to fully meet their debt obligations. 3. High collateral value.It’s usually possible to borrow up to 90 percent of the market value of your municipal bonds from such lenders as banks and brokerage houses since municipal bonds are free of certain restrictions imposed by the Federal Reserve Board on the use of other bonds as collateral. 4. Diversity.Thousands of different municipal bonds are available to suit the requirements of individual investors. 5. Marketability.A large nationwide market for municipal bonds exists, making them easy to sell when necessary.
Despite these advantages,I firmly believe that you should never buy municipal bonds for speculation.Purchase them for the tax-free income they produce and only in anticipation of “what you can get from them,not for them.”
If municipal bonds sound attractive—and there are many reasons they should— you must now do a preliminary “reality check”: 1. Investment. Are you prepared to make a fairly sizable investment? A minimum of $5,000 is usually required. 2. Yield. Is your tax bracket high enough to reap the tax-exempt advantage?
Remember, tax-exempt municipal bonds usually carry a lower rate of interest than taxable bonds. If you pay a fairly high tax rate, your tax savings will more than make up for the lower return. Those near the bottom of the tax rate tables, however, may be better off with another type of investment.
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3. Social security. Are you collecting social security benefits? You may have a problem with munis, because while the interest you receive from these bonds isn’t taxable for federal purposes, it may push your income higher and thus force you to pay federal income tax on up to 85 percent of your social security benefits.
Are Municipals Your Best Investment?
To determine whether or not you should invest in municipal bonds,you must figure out the taxable rate of return equivalent to that paid by tax-exempt municipals.For example,suppose you have a marginal income tax rate of 28 percent,and you are offered a tax-exempt municipal bond paying 6 percent interest.
You can use the following formula to help you determine the equivalent taxable yield (ETY) of any specific municipal bond you may be considering:
So:
Yieldonmuni taxbracket100 . = ETY
.06 − 1.00 .28 06 72 or ETY. .% 083 83
First you take the difference between your marginal tax rate and 100 percent,and then you divide this into the rate paid by the tax-exempt bond.Since your marginal tax rate is 28 percent,the difference between this and 100 percent is 72 percent.Divide 72 percent into 6 percent,and you obtain a result of 8.3 percent.Thus,a tax-exempt interest rate of 6 percent is equivalent to a taxable interest rate of 8.3 percent for someone in the 28 percent tax bracket.
Table12.1 shows several typical tax-exempt interest rates along with the equivalent taxable yield for investors in various tax brackets.For example,in the above situation,for an investor in the 28 percent tax bracket,a 6 percent tax-exempt yield is equivalent to an 8.3 percent taxable yield.
Table 12.1 Taxable-Equivalent Yields
Tax-Free Federal Tax Rates Yield % 15% 28% 31% 36% 39.6%
3.50 4.12 4.86 5.07 5.47 5.79 3.75 4.41 5.21 5.43 5.86 6.21 4.00 4.71 5.56 5.80 6.25 6.62 4.25 5.00 5.90 6.16 6.64 7.04 4.50 5.29 6.25 6.52 7.03 7.45 4.75 5.59 6.60 6.88 7.42 7.86 5.00 5.88 6.94 7.25 7.81 8.28 5.25 6.18 7.29 7.61 8.20 8.69 5.50 6.47 7.64 7.97 8.59 9.11 5.75 6.76 7.99 8.33 8.98 9.52 6.00 7.06 8.33 8.70 9.38 9.93 6.25 7.35 8.68 9.06 9.77 10.35 6.50 7.65 9.03 9.42 10.16 10.76 6.75 7.94 9.37 9.78 10.55 11.18 7.00 8.24 9.72 10.14 10.94 11.59
This taxable-equivalent yield of 8.3 percent means that you would need a taxable instrument paying almost 9 percent to equal your 6 percent taxexempt bond.By using this table,you will be able to determine the type of taxable return you would have to receive to exceed the tax-exempt return from your muni.Also,bear in mind that state tax is not considered in this example, so your yield is actually higher than 8.3 percent.
Are Municipals a Risky Investment?
As with any other investment,risk is a factor to consider in purchasing municipal bonds.Like corporate bonds,municipal bonds are rated by two major independent rating services:Moody’s and Standard & Poor’s.The AAA rating is the highest;the C rating is the lowest.In general,the lower the rating,the higher the yield.However,I don’t recommend that you purchase bonds with a rating lower than A,since the slightly higher interest rate you may be offered on the lower-rated bond isn’t worth the sacrifice in safety.Also,when financial
Believe it or not, you can virtually eliminate the risk in buying municipal bonds if they are covered by insurance. The secret (which isn’t so secret) is to buy bonds that carry a third-party guarantee offered by companies such as the Municipal Bond Insurance Association. If the municipality should fail, the insurer will continue to make timely payments of interest and principal as agreed upon at the time of purchase. In addition, the insurance will add to the liquidity of the investment since potential buyers appreciate the greater safety of the insured bonds.
times are uncertain,investors will look for high-quality bonds even though they do produce a lower yield.
Here’s how the insurance concept works.When a municipality issues muni bonds,the city’s or state’s credit is on the line.If bonds are somewhat lower rated,the municipality must pay higher-than-normal interest on the issued bonds.To save money,it may purchase insurance that guarantees that all payments of principal and interest will be made on time.It thus may appear that the insurance is free to the investor,but that is not true.Since the insurance raises the quality of the municipality’s credit,the yield on the bond issued will be lower.And one more point,because the cost/yield difference between an insured and an uninsured bond is narrow,the insurance has become a “good buy.”
Can Municipal Bonds Be Called Back?
Callability is a significant factor affecting the value of municipal bonds.Bonds that offer higher interest rates than what is presently being offered are most likely to be called in,because the issuer will want to redeem these costly older bonds and replace them with new ones paying lower yields.And this is so true today.When a bond is callable,it may be redeemed by the issuing agency prior to the maturity date,usually within 10 years after issue,and usually at a premium (2 percent)—$1,020 for each $1,000 face value of the bond.Of course, this places a lid on potential profits,which may be a significant loss to you if interest rates decline greatly after the bond is issued.Look what happened to the drop in interest rates from 2004 to 2006.Many bondholders could have had their higher-yield bonds called back.
Are There Strategies in Purchasing Municipal Bonds?
One method of diversifying a bond portfolio is a technique known as laddering.The idea is to purchase bonds maturing in different years.Therefore, if rates have risen when a bond matures,you will be able to reinvest the proceeds into an instrument paying the new high yield.Conversely,if interest rates should fall,a portion of your holdings will still earn interest at the higher (earlier) rates.
How Do You Find the Best Bond Value?
Okay.You’re ready to buy municipal bonds.Surprise! Unlike stocks,they are not listed on any exchange,making it that much harder to gauge prices.Follow these guidelines,and you’ll be a smart shopper:
1.Get quotes from several brokers before buying bonds.Prices of previously issued bonds vary greatly from dealer to dealer since each sets his or her own profit margin. 2.Be aware that the difference between what the broker pays for the bond (known as the bid price) and its selling price (known as the ask price) is the spread.Brokers don’t charge commissions on bond trades,but make their money on the spread,which is quoted in basis points (hundredths of a percentage point). 3. Remember:The longer the maturity and the smaller the trade,the wider the spread. 4.Ask the broker what he or she would pay to buy back the bond on the following day.The answer will reveal any hidden charges such as fees and markups. 5.Consider buying new issues only.The issuer pays the dealer’s markup on those,and so you’ll get the best price no matter where you buy.
Bottom line:Seek out all information before purchasing.
And on the topic of information,the jawbone of an ass is just as dangerous today as it was in Samson’s time.
It’s a Wrap
• Tax-free municipal bonds can be a good choice for those in the 28 percent tax bracket and above. • Tax exemption, relative safety, high collateral value, diversity, and marketability make municipal bonds worth considering. • The downside of tax-free munis is high minimum investment requirements,lower yields,and the fact that they can be recalled by the issuer. • Municipal bonds are rated from AAA (least risk) to C (most risk).Risk can be reduced by purchasing insured bonds and by laddering (buying bonds that mature in different years).
