Investing in Municipal Bonds
Municipal bonds, or munis, are issued by state and local governments. They are used to fund projects like road construction or improving schools. The nice thing about municipal bonds is that they’re typically exempt from federal taxes. Sometimes they are exempt from state & local taxes as well. Because of the federal tax savings, municipal bonds are typically issued and trade at lower yields. You can calculate a tax-equivalent yield by utilizing the formula below.
Calculating the tax-equivalent yield is easy. Take your current tax rate, say 25%, and subtract it from 100% = 75%. Then take the interest rate on the municipal bond, let’s say 3.5% divide it by 75% = 4.667% tax-equivalent yield.
When to use Municipal Bonds
It’s best to hold municipal bonds in a taxable brokerage account. Calculating the tax-equivalent yield will help when comparing if you should purchase a municipal bond or a treasury bond. Below is an example of earnings on $100,000 at various tax brackets:
In the above example, if you were in the higher tax bracket of 31%, purchasing muni bonds makes a lot of sense. If you are in a tax bracket lower than 31% purchasing taxable treasuries allows you to earn more money. Additionally, it does not make sense to hold munis in tax-advantaged accounts such as an IRA or 401k.
It is best to buy individual bonds versus a bond fund. They can be purchased in denominations of $5,000. Bonds are meant to be held to maturity to preserve principal. However, if you need to sell your muni bond early, you do have the potential of losing principal. Make sure you have calculated your shorter-term cash flow needs so bond investments can be held to maturity.
A bond fund is more like a stock which has greater market fluctuations. Additionally, you don’t know the type of bonds are in the fund, so it creates greater risk. While bond funds can be nice for a small investment, I like individual bonds for greater preservation on principal.
Credit Quality
The other consideration when purchasing muni bonds is the credit quality. I like to stay with General Obligation (GO) bonds with a credit rating of AA/Aa or higher. General Obligation typically means that it is covered by a tax levy on all property in that location. The default rate is extremely low.
Adding municipal bonds to your portfolio can provide income along with tax savings. They can be purchased individually just like a Treasury bond or a DTC CDs. Make sure you pick high quality bonds with AA/Aa or better. With the upcoming 2024 election, the winner could impact taxes and that will impact your investment decisions.
