Municipal bonds (often referred to as “munis”) can be attractive to income-seeking investors because they provide an income stream exempt from federal and, in certain cases, state and local income taxes. Like other fixed-income investments, munis involve risk. But as part of a broadly diversified portfolio, they can offer you an effective way to increase your after-tax earnings.

Invest in State and Local Projects

Municipal bonds are debt securities issued by state and local governments — or entities on their behalf — to generate funds for various public needs. Examples include toll roads, schools and hospitals, as well as general use bonds of cities, counties and states.

For investors, the main selling point of munis is that their income is exempt from federal income taxes. What is more, if you live in the state in which the bonds are issued — or if you buy bonds issued by U.S. territories, such as Puerto Rico or Guam — the securities’ interest payments may also be exempt from state and local taxes. One federal exception is that not all municipal bond income is exempt from the alternative minimum tax.

Beneficial for Affluent Investors

Municipal bonds may be appropriate for investors looking to manage their tax exposure and traditionally have been of greatest use for upper-income taxpayers. In general, the higher your combined federal, state and local income tax rate, the more valuable munis become. (See the Sidebar, “Comparing Apples to Apples”).

Consider that the top federal income tax rate is 39.6% and high-net-worth individuals face an additional 3.8% Medicare tax on net investment income. The bite is even greater for residents of high-tax states. In California, for example, the top state tax bracket is now 13.3%, meaning that, for every dollar earned over $1 million, you would potentially face a combined income tax rate of more than 55%.

Consider the Risks

As with any fixed-income product, municipal bonds are vulnerable to rising interest rates. Investors saw this first hand in the spring and summer of 2013 when munis experienced big price declines across the board.  However, these recent declines followed several years of gains thanks to historically low-interest rates.

Municipal bonds also face credit risk — the risk that a bond issuer will not be able to repay its debts. Even the mere idea of a default can cause bond prices to drop. Last year, widely publicized credit problems, such as Detroit’s bankruptcy filing and Puerto Rico’s credit rating downgrade, weighed on nearly the entire municipal bond market. Even securities that seemed highly creditworthy lost value because investors were worried about the potential for additional bad news.

Although credit risk is a real challenge — especially when dealing with lower-rated municipal bonds — it is worth noting that munis have historically defaulted much less than comparable corporate bonds. According to credit rating agency Moody’s Investor Service, just 0.13% of municipal bond issuers defaulted on their debt between 1970 and 2012, compared to 11.17% of corporate bond issuers. And for bonds rated Aaa and Aa — the top two credit ratings — just 0.01% of municipal bond issuers defaulted during that time, compared to 1.34% of similarly rated corporate bonds.

This does not mean that corporate bonds are necessarily a worse investment. Many corporate bonds offer higher yields as compensation for the increased default potential and higher taxes. But it does suggest that the credit challenges faced by a few states and municipalities in recent years are not necessarily representative of the risks involved with tax-exempt debt.

Individual Bonds vs. Mutual funds

Even though you can buy individual bonds directly from municipal issuers, most investors find it more efficient to gain exposure to this asset class through mutual funds. The latter provides a few significant advantages — for example, they are more liquid and generally provide better diversification than most investors can achieve on their own buying individual bonds.  One disadvantage is that certain states, like Illinois, do not allow bonds purchased through mutual funds to be exempt from state and local taxes.

Your financial advisor can be a valuable resource as you determine whether municipal bonds make sense for your situation and, if so, how best to incorporate them into your portfolio.

If you have any questions or would like to learn more about municipal bonds, contact Adam Pechin at [email protected] or call him at 312.670.7444.

Sidebar:  Comparing Apples to Apples

Because they are tax-free, municipal bonds generally offer lower yields than comparable taxable bonds. That said, when you consider how taxes affect municipal vs. taxable bonds, you may find that municipal bonds provide the better deal.

To compare taxable and tax-free bonds, calculate the latter’s tax-equivalent, or before-tax, yield by dividing the tax-free yield by 1 minus your tax rate. For example, let us say your municipal bond fund has a tax-exempt yield of 4%, and you are comparing it to a taxable fund yielding 5.75%. If you are in the top federal tax bracket of 39.6%, you would have a before-tax yield of 6.62% — well above the 5.75% provided by the taxable fund. (Bear in mind that this does not consider state and local taxes or the 3.8% net investment income tax.)

But what if you are in the 25% federal tax bracket? In this case, your tax-equivalent yield would be 5.33%, making taxable bonds your more attractive option.