What is a Municipal Bond?
Municipal bond investing is a popular income choice for many American. The muni bonds are debt securities issued by municipal authorities like States, Counties, Cities and their related companies. Municipal bonds or “munis” are issued to fund general activities or capital projects like building schools, roads, hospitals and sewer systems. The size of the muni bond market reaches $3.7 trillion dollars. There are about $350 billion dollars of Muni bond issuance available every year.
In order to encourage Americans to invest in Municipal Bonds, US authorities had exempted the interest (coupon income) of the muni bonds from Federal taxes. In some cases when the bond holders reside in the same state where the bond was issued, they can be exempted from state taxes too.
Types of Municipal Bonds
General obligation bonds are issued by municipal entities to finance various public projects like roads, bridges, and parks. General obligation bonds are backed by the full faith and credit of the issuing municipality. Usually, they do not have a dedicated revenue source. The local authorities commit their abundant resources to pay off the bonds. Municipals rely on their unlimited power to tax residents to pay back bondholders.
Revenue bonds are backed by income from a particular project or source. There is a wide diversity of types of revenue bonds, each with unique credit characteristics. Municipal entities frequently issue securities on behalf of other borrowers such as water and sewer service, toll bridges, non-profit colleges or hospitals. These underlying borrowers typically agree to repay the issuer, who pays the interest and principal on the securities solely from the revenue provided by the conduit borrower.
Taxable Bonds. There is a smaller but growing niche of taxable municipal bonds. These bonds exist because the federal government will not subsidize the financing of certain activities, which do not provide a significant benefit to the general public. Investor-led housing, local sports facilities, refunding of a refunded issue and borrowing to replenish a municipality’s underfunded pension plan, Build America Bonds (BABs) are types of bond issues that are federally taxable. Taxable municipals offer higher yields comparable to those of other taxable sectors, such as corporate or government agency bonds.
Investment and Tax Considerations
Tax Exempt Status
With their tax-exempt status, muni bonds are a powerful tool to optimize your portfolio return on an after-tax basis.
Muni Tax Adjusted Yield
So why certain investors are flocking into buying muni bonds? Let’s have an example:
An individual investor with 35% tax rate is considering between AA rated corporate bond offering 4% annual yield and AA-rated municipal bond offering 3% annual yield. All else equal which investment will be more financially attractive?
Since the investors pays 35% on the received interest from the corporate bonds she will pay 1.4% of the 4% yield to taxes (4% x 0.35% = 1.4%) having an effective after-tax interest of 2.6% (4% – 1.4% = 2.6%). In other words, the investor will only be able to take 2.6% of the 4% as the remaining 1.4% will go for taxes. With the muni bond at 3% and no federal taxes, the investor will be better off buying the muni bond.
Another way to make the comparison is by adjusting the muni yield by the tax rate. Here is the formula.
Muni Tax Adjusted Yield = Muni Yield / (1 – tax rate) = 4% / (1 – 0.35%) = 4.615%
The result provides the tax adjusted interest of the muni bond as if it was a regular taxable bond. In this case, the muni bond has 4.615% tax adjusted interest which is higher than the 4% offered by the corporate bond.
Effective state tax rate
Another consideration for municipal bond investors is the state tax rate. Most in-state municipal bonds are exempt from state taxes while out-of-state bonds are taxable at state tax level. Investors from states with higher state tax rates will be interested in comparing the yields of both in and out-of-state bonds to achieve the highest after-tax net return. Since under federal tax law, taxes paid at the state level are deductible on a federal income tax return, investors should, in fact, consider their effective state tax rate instead of their actual tax rate. The formula is:
Effective state tax rate = State Income Tax rate x (1 – Federal Income Tax Rate)
Example, if an investor resides in a state with 9% state tax and has 35% federal tax rate, what is the effective tax rate:
Effective state tax rate = 9% x (1 – .35) = 5.85%
If that same investor is comparing two in- and out-of-state bonds, all else equal she is more likely to pick the bond with the highest yield on net tax bases.
One important consideration when purchasing muni bonds is their Alternative Minimum Tax (AMT) status. Most municipal bond will be AMT-free. However, the interest from private activity bonds, which are issued to fund stadiums, hospitals, and housing projects, is included as part of the AMT calculation. If an investor is subject to AMT, the bond interest income could be taxable at a rate of 28%.
Social Security Benefits
If investors receive Medicare and Social Security benefits, their municipal bond tax-free interest could be subject to taxes. The IRS considers the muni bond interest as part of the “modified adjusted gross income” for determining how much of their Social Security benefits, if any, are taxable. For instance, if a couple earns half of their Social Security benefits plus other income, including tax-exempt muni bond interest, above $44,000 ($34,000 for single filers), up to 85% of their Social Security benefits are taxable.
Muni bonds are good choice to boost diversification to the investment portfolio. Historically they have a very low correlation with the other asset classes. Therefore, municipal bonds returns have observed a smaller impact by developments in the broader stock and bond markets.
For example, municipal bonds’ correlation to the stock market is at 0.03%. Their correlation to the 10-year Treasury is at 0.37%.
Interest Rate Risk
Municipal bonds are sensitive to interest rate fluctuations. There is an inverse relationship between bond prices and interest rates. As the rate go up, muni bond prices will go down. And reversely, as the interest rates decline, the bond prices will rise. When you invest in muni bonds, you have to consider your overall interest rate sensitivity and risk tolerance.
Similar to the corporate world, the municipal bonds and the bond issuers receive a credit rating by the major credit agencies like Moody’s, S&P 500 and Fitch. The credit rating shows the ability of the municipality to pay off the issued debt. The bonds receive a rating between AAA and C with AAA being the highest possible and C the lowest. BBB is the lowest investment grade rating, while all issuance under BBB are known as high-yield or “junk” bonds. The major credit agencies have different methodologies to determine the credit rating of each issuance. However, historically the ratings tend to be similar.
Unlike corporations, which can go bankrupt and disappear, municipals cannot go away. They have to continue serving their constituents. Therefore, many defaults end up with debt restructuring followed by continued debt service. Between 1970 and 2014 there were 95 municipal defaults. The vast majority of them belong to housing and health care projects.
In general, many investors consider municipal debt to be less risky. The historical default rates among municipal issuances is a lot smaller than those for comparable corporate bonds.
Limited secondary market
The secondary market for municipal bonds sets a lot of limitations for the individual investor. While institutional investors dominate the primary market, the secondary market for municipal bonds offers limited investment inventory and real-time pricing. Municipal bonds are less liquid than Treasury and corporate bonds. Municipal bond investing tends to be part of a buy and hold strategy as most investors look for their tax-exempt coupon.
The municipal bond market is very fragmented due to issuances by different states and local authorities. MUB, the largest Municipal ETF holds 2,852 muni bonds with the highest individual bond weight at.45%. Top 5% holdings of the ETF make 1.84% of the total assets under management. For comparison, TLT, 20-year old Treasury ETF, has 32 holdings with the largest individual weight at 8.88%. Top 5% make up 38.14% of the assets under management.
About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. Hs firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.