Basic Finance Bootcamp Lesson 5: Municipal Bonds

You’re probably sick of talking bonds by now, but we have one more category that we have to cover before you have all the basics that you need in this category. This last major bond category is municipal bonds. As the name implies, municipal bonds are bonds issued by local and state governments. While most of the issues are the same, the tax implications are just a little different and are worth exploiting, particularly if you are in my tax bracket. So, without further ado, here is your introduction to municipal bonds.

Municipal Bonds

Municipal bonds (aka, “munis”) are debt issued by state and local governments. Be aware that the term “local” does not only refer to cities, as might be assumed. Counties, school districts, water boards, and any other local government entity that has taxing power can raise money to support its activities by issuing municipal bonds. Investors can purchase these bonds through their broker, just as they can bonds issued by corporations, the U.S. Treasury, and federal government agencies.

There are two basic categories of municipal bonds: general obligation (GO) bonds and revenue bonds. A general obligation bond is backed by the full faith and credit (i.e., taxing power) of the issuing government, while a revenue bond is backed by the proceeds of a specific project. For example, revenue bonds are often issued to finance airports, toll bridges, turnpikes, and similar publicly-used properties. An industrial revenue bond is issued by a state or local government, with the proceeds used to benefit a business venture, such as an industrial park. The revenues generated by the venture, such as the lease payments made by the businesses located in the industrial park, are used to pay the bondholders.

Revenue bonds tend to be the riskier of the two types of munis since the bond will go into default if the project doesn’t produce sufficient revenues to make the promised interest and principal payments as scheduled. Historically, revenue bonds issued to support healthcare or housing projects have been the worst performers. According to information obtained from Moody’s Investors Service, almost 75% of the defaults on revenue bonds from 1970 through 2011 were in these two industry sectors.

Moody’s reports that during that same 41-year time period, only 5 GO bonds went into default. This being said, not all general obligation bonds are created equal. Thus far, GO’s issued by states have an extremely good record. Only one state default in the 20^th century caused individual investors to lose money, and that was the state of Arkansas in 1933. But some state and local governments have enacted laws that constrain their taxing ability, and some now issue “limited” GO bonds that specify that only a portion of the tax dollars collected will be directed to pay the bondholders.

As with other bonds, you can get an idea of the likelihood of default by looking at the bond’s rating. Moody’s and Standard & Poor’s both rate municipal bonds, using the same system that they do for corporate bonds and Treasuries. According to the data collected by Moody’s for the 1970 to 2011 time frame, significantly more corporate bonds went into default than municipal bonds. The municipal bond defaults across all ratings categories (i.e., Aaa, Aa, A, etc.) amounted to 0.13%, while the corporate bond default rate was 11.17%. This being said, not all bonds—corporate or municipal—are rated (the issue may be deemed too inconsequential, etc.), but the default difference is still remarkable. And there are significantly more municipal bonds on the market than corporate bonds. In fact, there are over 1.5 million municipal bonds currently out there.

One of the biggest advantages associated with municipal bonds is that the interest received is free from federal taxation. If you read the previous post on U.S. Treasury securities, you might remember that there is no federal tax exemption on the interest paid by those instruments. Furthermore, if you are a resident of the state or locality that has issued the bond, the interest will be exempt from state and local taxes, too.

For example, if you are a resident of Colorado and invest $5,000 in a bond issued by the Colorado Department of Transportation that pays an annual coupon rate of 5.5%, you will receive $275 in interest each year (paid semiannually) until the bond matures (in this instance, on June 15, 2014). You will not have to pay federal income tax on this amount, nor will you have to pay Colorado income tax on this interest. However, if you are a resident of Ohio and invest in this bond, you will have to pay income tax to the state of Ohio on the $275 interest income, although it will not be subject to federal income tax. The state of Ohio wants to encourage its residents to invest in its state and local bonds, not those of another state.

Because they pay tax-exempt interest, municipal bonds offer lower yields than corporate bonds in the same risk class. But the question is, are the tax savings worth the lower yield? This depends on your marginal tax rate, and there’s a very easy calculation that can help you determine which bond investment is better for you personally from a tax standpoint. To keep it simple, we’ll just consider federal taxes since each state has its own tax rate schedule, and a few states don’t levy an income tax.

Let’s assume you are deciding between two bonds that are selling at par–a fully-taxable corporate bond and a tax-exempt municipal bond. Both have the same AA rating, so they are of similar risk. The corporate bond is yielding 4% while the municipal bond is yielding 3%.

If you pay taxes at the marginal rate of 15%, you will be left with 4% x (1 – 0.15) = 3.4% after you pay Uncle Sam the taxes owed on the interest paid on the corporate bond. Since this is higher than the muni bond yield, you are better off investing in the corporate bond.

But let’s suppose your marginal tax rate is 28%. Then you will be left with 4% x (1 – 0.72) = 2.88% after paying Uncle Sam the taxes due on the corporate bond interest income. In this case, the muni bond, which is yielding a tax-free 3%, is the better deal for you.

Of course, taxes are not the only investment consideration, as we’ve noted in previous blog posts, but if you’re in one of the higher tax brackets, you might want to take a closer look at including some municipal bonds in your investment portfolio.

So that’s all I have to say about bonds. If you have questions, please let me know. Also, don’t forget to sign up for my newsletter–lots of exciting things coming up in the future. Believe me, I know this stuff here is not that exciting or exotic but take it like medicine.