Investing In Municipal Bonds

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What Is a Municipal Bond?

Municipal bonds are debt obligations issued by state, city and local governments, generally to raise capital for their daily operations or to fund specific projects, such as the development of roads, bridges, hospitals or schools. Generally speaking, the income earned on municipal bonds is exempt from federal tax, and when purchased by a resident of the state issuing the bond, interest may be exempt from state tax as well. Local taxes, if any, also may be exempted.

The two most common types of municipal bonds are general obligation (GO) bonds and revenue bonds.

  • General obligation bonds: GOs are unsecured bonds backed by the full faith and credit of the issuing government. These are generally paid off with funds from taxes or fees, and are considered the safest of municipal issues. For that reason, they offer lower yields.
  • Revenue bonds: Revenue bonds are issued to fund projects that will eventually generate revenue (e.g., a toll road). That revenue is used to pay off the bonds. Because they are considered somewhat riskier than GO bonds, revenue bonds typically offer higher yields.

Many investors appreciate not only the tax benefits associated with municipal bonds, but also the fact that, by investing in them, they are helping to support projects and pursuits that can benefit their local communities.

The Appeal of Municipals

In addition to the tax advantages and community-development benefits associated with municipal securities, they also offer investors a reliable source of income and high degree of safety relative to many other types of fixed income assets.

 

Reliable Income, Relative Safety

Municipal bonds pay interest to holders on a regular basis, often semiannually. You are guaranteed this income if you hold the bond to maturity. When your bond matures, your principal is returned to you.

Generally speaking, municipal bonds are considered safer than corporate bonds, for the simple fact that governments are less likely than companies to fail and default on their obligations.

Municipal Bonds Historically Have Low Default Rates
Corporate vs. Municipal Bonds, 1990-2007
Municipal Bonds
Corporate Bonds
Five-year cumulative default rate
0.10%
1.20%
Default rate for A-rated bonds
0.00%
0.65%
Default rate for BBB-rated bonds
0.66%
3.11%
Average rating assigned by Fitch
A+
BBB

Source: FitchRatings. Select statistics for Fitch-rated investment-grade bonds. Past performance is no guarantee of future results.

Given their inherent tax advantage, municipal bonds almost always come with lower yields than taxable bonds, such as Treasury bonds and corporate bonds. Historically, munis trade at 85% to 90% of their Treasury counterparts, levels that factor in the impact of taxes.

Investors are wise to determine the taxable equivalent yield on a tax-exempt bond to determine whether it represents a good value relative to a taxable investment. Generally speaking, investors in high tax brackets benefit most from an investment in municipal bonds.

 

Calculating a Bond’s Taxable Equivalent Yield (TEY)
Investor’s tax bracket = 35%
Tax-exempt bond yield = 5%
TEY = 5 (the tax-exempt yield being offered) ÷ 0.65 (1 minus the investor’s tax bracket of 0.35)
TEY = 7.69%
This hypothetical investor would need to find a taxable investment paying more than 7.69% to outpace the return on the 5% tax-exempt bond (on an after-tax basis). For investors subject to state tax as well, the benefits of tax-exempt investing would be even more dramatic.
Bond Insurance

Some municipal bonds are underwritten by third-party bond insurers in order to enhance their credit ratings. The insurers guarantee payment of principal and interest in case the bond issuer were to default. However, as indicated earlier, natural (uninsured) municipal bonds are generally of high quality in and of themselves. The default rate on municipal bonds as a class is less than one-half of 1%, and no natural AAA-rated muni has ever defaulted.

When the rating agencies began downgrading the municipal bond insurers in 2007 and 2008, the market started to price even insured munis based on their underlying ratings. At that point, bond insurance started to add little value in the municipal market.

The Many Flavors of Munis

Although GO and revenue bonds are the two large buckets of municipal bonds, munis can come with a number of features that increase the available options for investors. Following are two examples:

  • Pre-refunded municipal bonds: Pre-refunded bonds (pre-res) offer a high level of relative safety because they are essentially backed by US Treasury bonds. Here is how it works: Pre-res are municipal bonds that were issued in relatively high interest rate environments. As rates fall, the municipality may choose to refinance the higher-interest debt, issuing a new bond at the prevailing lower interest rate. Now, the municipality has sufficient funds to pay off the original bond. However, that original bond may not be callable. In such an instance, the municipality may opt to buy Treasuries, place them in an escrow account and use the interest proceeds to pay the interest on the original muni until it is callable. The first bond becomes known as a prerefunded bond and is seen as quite safe, generally receiving a AAA rating.
  • Zero-coupon municipal bonds: Zero-coupon bonds, either taxable or tax-exempt, pay interest at maturity rather than at regular intervals throughout the life of the bond. Generally, zeros are sold at a discount to their face value, with the promise of returning full face value to the investor at maturity. Here is the difference between taxable and tax-exempt zeros: Taxable zero-coupon bonds accrue interest each year and holders must pay tax on it, even though they do not receive the interest until the bond is sold or matures. For tax-exempt issues, there is no federal income tax on the accrued interest.

Like their taxable counterparts, municipal bonds also come in all maturity ranges, from very short-term tax-exempt money market instruments to 30-year bonds. While a high-quality asset class in general, there are high yield municipal bonds (lower-rated, higher-yielding) options as well. Investors also can choose to invest in a national municipal bond (exempt from federal taxes) or state-specific municipal bonds (exempt from federal, state and potentially local taxes as well).

 

Munis can come with a number of features, effectively increasing the options available to investors. For example:

  • Choice of maturity-short, intermediate and long
  • National or state-specific bonds
  • High yield munis
  • Pre-refunded bonds
  • Zero-coupon bonds

 

How to Invest

 

Individual Bonds

Investors may opt to purchase municipal bonds directly from the issuer. Municipal bonds are bought and sold in the over-the-counter market rather than on an organized exchange. The Municipal Securities Rulemaking Board establishes the guidelines for the municipal market and is subject to the oversight of the Securities and Exchange Commission. Municipal bonds are typically issued in par values of $5,000. Most investors hold municipal bonds to maturity, when their original investment is returned to them, and collect the regular income they generate in the interim. If an investor opts to sell a municipal bond prior to maturity, he or she receives the current market price for the bond, which may be more or less than the purchase price.

 

Municipal Bond Mutual Funds

An efficient and affordable way for the average investor to gain exposure to municipal bonds is through investment in a professionally managed municipal bond mutual fund. A mutual fund offers greater diversification than an average investor could achieve by making individual purchases of bonds on his or her own. The minimum investments are usually much lower and fund shares are easily exchanged or liquidated. Muni bond funds typically have no maturity date, but they pay income monthly or quarterly, whereas the bonds themselves generally make distributions semiannually. Investors in municipal bond mutual funds benefit from the same tax advantages as those who purchase individual bonds, although certain sales charges and fund expenses will apply.

Investing in a municipal bond mutual fund offers advantages such as:

  • Monthly or quarterly income
  • Professional portfolio management
  • Diversified mix of investments
  • Liquidity
  • Low initial investment amount
  • Ability to exchange fund shares within the same family of mutual funds

A Word About Risk

As with other fixed income investments, the two main risks associated with municipal bonds are interest rate risk and credit risk. Bond prices move in the opposite direction of interest rates. When rates rise, bond prices fall and vice versa. Generally speaking, bonds with shorter maturities react less to interest rate movements than do longer-dated issues.

Credit risk refers to the possibility that the issuer of a bond might default on its obligations. Although the likelihood of municipal defaults is lower than in the corporate space, there have been instances (such as Orange County, California, in 1994) where municipalities have filed for bankruptcy.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Investment involves risk. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income may be taxable. Some investors may be subject to Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable. A fund concentrating in a single state is subject to greater risk of adverse economic conditions and regulatory changes than a fund with broader geographical diversification.

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