Think Twice Before Buying Tax-Free Municipal Bonds

Investors favor municipal bonds, or “ munis, ” for two main reasons. They are exempt from federal taxes, and they are relatively low-risk investments .

While stable, income-producing bonds warrant a situation in any well-diversified portfolio, there are built-in drawbacks to owning munis. Individuals interested in purchasing them need to consider respective factors before making muni bonds part of their investing strategy .

  • The interest you receive from muni bonds is free from federal taxes but there may be state or local taxes or both.
  • Beware: If you receive Social Security, your bond interest will be counted as income in calculating the taxable amount of your Social Security income. That could increase the amount you owe.
  • The interest rate paid on muni bonds is generally lower than rates for corporate bonds. You need to determine which deal has the better real return.
  • On the plus side, highly-rated municipal bonds are generally very safe investments compared to almost any other investment. The default rate is tiny.
  • As with any bond, there is interest rate risk. If your money is tied up for 10 or 20 years and interest rates rise, you’ll be stuck with a poor performer.

Understanding municipal Bonds

A municipal bond is a loanword to a department of state or local government or an entity under its manipulate. A government or means might issue a bond to fund its routine expenses or to undertake a specific public undertaking such as the construction of a bridge .

As with any attachment, a muni is an investment in debt. The investor effectively lends a sum of money to a government or agency and is paid a regular stream of interest in return. At the end of a predetermine period of time, the investor ‘s money is returned .

Why Investors Buy Bonds

Investors buy bonds in order to create a authentic stream of income ( from the matter to payments ) while preserving their capital ( since they ‘re getting their money back in the end. )

many investors devote a helping of their overall holdings to bonds in order to offset the greater risks implicit in in about any other type of investment, notably stocks. That is the purpose of diversification : Low-risk investments cushion potential losses from higher-risk investments .

even bonds are not risk-free. The gamble is that the issuer will default on its debts .

Investors can judge the risk level of a chemical bond they are considering by checking the bond ‘s rat. All bonds sold in the U.S. are rated by one of three bond-rating agencies : Moody ‘s Investors Service, S & P Global, or Fitch Ratings. Bond ratings are based on an analysis of the creditworthiness of their issuers .

How municipal Bonds Differ

The big deal point of municipal bonds is their federal tax-exempt status. That is, the matter to payments are not taxed at the federal level .

Some states do not tax municipal bonds, but others do. It is, not amazingly, complicated. Seven states have no income tax at all, therefore bond interest is a arguable point. other states do n’t tax in-state bonds but do tax out-of-state bonds in some circumstances.

There are a count of reasons to look carefully at municipal bonds before taking the plunge, and to compare them against other choices for investing your money :

  • Tax-free municipal bonds are not necessarily entirely free of taxes. As noted, there may be state income taxes on the interest. If you receive Social Security, your muni bond interest will count towards your adjusted gross income, thus potentially increasing the taxable amount of your Social Security income. Less commonly, there may be tax implications related to the de minimus tax and the alternative minimum tax.
  • Unless you just have an aversion to paying taxes, the point of tax-free municipal bonds is to improve the overall return on your money. Be careful that you don’t choose an inferior return on your money in order to minimize your tax bill.
  • Municipal bonds, like all bonds, pose interest rate risk. The longer the term of the bond, the greater the risk. If interest rates rise during the term of your bond, you’re losing out on a better rate.

Use the tax-equivalent-yield formula to compare the actual tax return on a muni shackle with a corporate bond.
The formula is : tax equivalent move over = tax-exempt Yield / ( 1 – Tax rate ).
translation : That ‘s the succumb that the muni must have in addition to its union tax-exempt condition to be equal to the yield of a corporate bond.

Comparing substantial Returns of Muni Bonds vs. Corporate Bonds

Bonds used to fund local anesthetic and state government projects like buildings and highways are afforded tax-exempt security status at the federal level. Plus, people who purchase bonds issued by their states or localities may not be required to pay state of matter or local taxes on the sake .

That means some municipal issues have triple tax-exempt condition .

These tax advantages are offset by lower interest yields. municipal bonds typically have lower coupon rates than similarly rated corporate issues with comparable maturities .

so, when considering munis, investors should compare the yields of taxable investment-grade and government bonds by using the tax-equivalent-yield formula. Tax-equivalent give ( TEY ) is the yield that a taxable bind must have to equal or exceed the tax-adjusted yield of a municipal bond. Tax equivalent Yield = Tax-Free Yield/ ( 1 – Tax rate ) .

In general, higher-income investors ( with theoretically higher tax bills ) are likely to benefit more from municipal bonds than individuals in early tax brackets .

interest pace risk

The risks of default by governments that issue muni bonds in the U.S. are low. however, bonds by definition have interest rate risk, which is authoritative to investors who want to sell their bonds on the junior-grade market .

When matter to rates fall, a long-run investor may even face risk to their principal investment. A bondholder selling a 30-year emergence may receive less in principal than the bond initially cost .

Purchasing-Power risk

Over the past decade, annual inflation in the United States has ranged between -0.7 % ( in 2015 ) to a projected gamey of 5.4 % ( in 2021 ). Otherwise, it was 2.3 % or lower throughout that clock time .

This means that a 20-year municipal bond that yields 2.5 % to an investor in a 25 % tax bracket, or a 3.3 % tax-equivalent yield, would offer inflation-beating returns every year—right up until 2021, when it fails to get close to the rate of inflation .

Purchasing-power risk is the biggest potential drawback to investing money long-run in bonds. You ‘ll get your money back in the end, but it may be worth less to you than it was .

Investing entirely in low-yielding municipal bonds is a safe approach path but it could well mean giving up returns that exceed the pace of inflation and protect your purchasing power. A remainder between municipal bonds and ( relatively riskier ) stocks can offset that risk .

default risk

between 1970 and 2018, 0.16 % of all municipal securities rated by Moody ‘s Investor Service defaulted on their payments to investors. That ‘s why muni bonds are considered a relatively safe investment .

The acid test of muni bond resilience came with the COVID-19 pandemic as business activity ground to a arrest and taxable receipts halted with it. total defaults rose year-over-year to just 0.05 % of the $ 3.9 trillion of municipal bonds outstanding .

name risk

A adhesiveness that is issued with a callable choice adds another gamble to the investor. It means that the issuer can cancel the exit, pay off the principal and stop the sake payments. The issuer wants that option, in case interest rates drop well, giving it the opportunity to issue a new bond at a lower pastime rate .

Most municipal bonds are callable. Their investors will get their money back, but they ‘ll have to find a newly way to invest that money. A new investment in bonds will earn them less .

The alternate minimum tax can be a tax trap for muni shackle investors who have very high income from tax-shielded sources.

municipal Bond Tax Traps

As noted above, tax-exempt muni bonds are not always wholly tax-exempt .

Bonds are peculiarly attractive to senior citizens seeking a steadily stream of income for their retirement needs .

That makes Social Security income the most common pitfall for muni chemical bond investors. Although the bonds are income-tax-free at the federal flat, the income from muni bonds is counted towards the investor ‘s adjusted megascopic income. A higher adjusted gross income can raise the fortune of the taxpayer ‘s Social Security income that is taxable .

High-income individuals besides can run into the alternative minimum tax, which is aimed squarely at taxpayers with substantial income from tax-shielded sources.

How to Invest in Tax-Free Municipal Bond Funds

An investor can buy and sell bonds immediately through an on-line brokerage report .

They besides can be purchased through a full-service brokerage or a bank .

Another choice is to invest in an exchange-traded fund ( ETF ) or common store that invests in muncipal bonds.

tax-exempt Municipal Bond FAQs

here are the answers to some normally asked questions about municipal bonds.

What Is the average Rate of Return on a tax-exempt Municipal Bond ?

In recently 2021, interest rates were rising, and municipal bond rates were rising along with them .

As of Oct. 24, 2021, ten-year AAA-rated muni bonds returned 1.15 % compared to 0.95 % a week early. A 20-year AAA-rated bond returned 1.50 % compared to 1.35 % the week ahead. A 30-year AAA-rated bond returned 1.70 % compared to 1.55 % the workweek before .

Can You Lose Money on Municipal Bonds ?

You can lose the money you invest in municipal bonds if the issuer defaults. That risk is vanishingly humble, considering that defaults on municipal bonds reached 0.05 % of $ 3.9 trillion of outstanding debt in 2020, a time during which local tax revenues were decimated by the COVID-19 pandemic .

You besides could lose money on muni bonds if you are forced to sell the bonds on the secondary market at the wrong prison term. The price you get will be determined by the total dollar come of the remaining interest payments due, factoring in the prevail rates available on raw issues.

Which States and Cities Have the Best municipal Bonds ?

The best muni bonds from any issuer are rated AAA. They are issued by express and local anesthetic governments nationally and their bonds have been deemed AAA by one of the major evaluation agencies .

When a politics runs into economic trouble, its shackle ratings suffer ( but it besides will pay a better interest pace in rate to attract buyers ) .

After its 2013 bankruptcy, the city of Detroit missed payments on three of its general debt instrument bonds. That means it was responsible for three out of seven defaults on muni bonds rated by Moody ‘s Investors in that class .

The city has since managed to work its way back from a “ negative ” expectation to a “ stable ” lookout from S & P Global as of January 2021. Its great debt was rated BB- .

A bond rated AAA or close to it is one of the best municipal bonds. A bind issued by a local government that is teetering on the brink of bankruptcy is one of the worst .

Investors who do n’t care to keep an eye on the finances of country and local governments they invest in can invest in a bond reciprocal fund or ETF. It will be managed by person who gets paid to pay attention to these things.

Are Municipal Bonds Safe ?

A municipal attachment, or any bond for that matter, is safe deoxyadenosine monophosphate long as its issuer does not financially flop. fortunately, that ‘s highly improbable in the U.S. attachment market .

The attachment investor ‘s best auspices is to take care :

  • Check the bond rating. Defaults are rare, but they happen. A rating of AAA, AA, or A indicates an issuer that is on a sound financial footing.
  • Compare the real return on the municipal bond to other options for your money. It’s always nice to save money on taxes but not at the cost of a better return for a comparable risk elsewhere, such as in high-quality corporate bonds.

The Bottom Line

municipal or corporate bonds are a great alternate for investors who want to create a authentic stream of income, peculiarly during their retirement years .

Highly-rated bonds are by their nature very safe investments compared to about any other option and specially compared to stocks .

municipal bonds are, as advertise, absolve of federal taxes. That does n’t mean that the overall refund on a muni adhere will be the best available option for you .

You still have to do your ascribable application to choose the best municipal or bodied bonds for you or the best mix of the two. Another alternate is to invest in a bond ETF or reciprocal fund and let person else make the choices .

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Category : Finance

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