By: Douglas Charney
If you’re in a higher tax bracket and are looking for a way to help diversify your portfolio and potentially save money, municipal bonds may be worth consideration. Municipal bonds (or “munis,” for short) are IOUs issued by cities, counties or state governments to raise money for community projects such as highways, new schools and sewer systems, to name a few.
Before you rush out and add municipal bonds to your portfolio, consider the following features of this investment tool.
Not All Municipal Bonds Are the Same
There are two types of munis: General Obligation municipal bonds and Revenue municipal bonds. General Obligation bonds are backed by the issuer’s ability to tax and are typically used to finance such things as schools and sewer systems. Revenue munis are issued by special state and local governments sanctioned entities, such as a utility company.
General Obligation bonds promise to repay based on the full faith and credit of the issuer. As such, many investors consider these bonds to be more secure. These bonds also generally carry the lowest interest rate. Revenue bonds promise repayment from a specified stream of future income, such as income generated by a water utility company from payments by customers.
Municipal Bonds are Subject to Fluctuations
Munis, like other bonds, rise and fall in value in your portfolio, based on interest rates. Bond prices fluctuate inversely to changes in interest rates. A general rise in interest rates can result in the decline of your investment. Having a muni with a longer duration (meaning the time until the bond matures) usually means you have greater potential for shot-term gains or losses. Changes in the munis credit quality can also have a negative or positive effect on the bond’s price.
Municipal Bonds Have Many Benefits
As mentioned, munis can offer federal tax savings. They are also generally very liquid (meaning there is an active secondary market). However, there can be some price changes from when you bought the bond based on interest rates.
Munis tend to deliver consistent income due to their fixed rate of return, coupled with their interest payment structure. In general, munis pay interest payments every six months. One exception to that is Zero Coupon Municipal Bonds. Rather than pay interest, these bonds reinvest the money back into the bond, which is then paid out when it matures.
Municipal Bonds Have Portfolio Preferences
Municipal bonds preferences come in three versions: State Specific, State Preference, and National. State Specific portfolios hold only bonds from a client’s state or territory of residence. State Preference portfolios hold bonds from a client’s state or territory of residency, which together will generally account for 50 percent of the portfolio. The rest of the portfolio will be made up of munis issued by states from all over the country. National portfolios are made up of munis issued from all 50 states and all of the U.S. territories. National and State Preference portfolios are generally recommended over State Specific portfolios because they can have a higher yield and better diversification.
Municipal Bonds Have Quality Ratings
Moody’s and Standard and Poor’s are bond rating services that are best known and most used by investors. They assess the risk on bond issuers and assign grades based on the issuer’s ability to meet the promised principal and interest payments. Many issuers and traders of munis often wrap the securities in insurance to guarantee the timely payments of interest and principal in event of default.
Municipal Bonds Can Compare to Corporate Bonds
Many investors may have a difficult time deciding between fully taxable corporation bonds and tax-free muni bonds. The following formula can help you determine the taxable equivalent. Note that the taxable equivalent yield is the pre-tax yield that the taxable bond needs to have in order to equal the tax-fee yield of the muni.
If the municipal bond yield is 5 percent, and the client’s tax bracket is 33 percent, the formula would be as follows: 5% divided by (100%-33%) =7.46%. This means the muni is equivalent with a corporate bond that yields 7.46% or to put it another way, a municipal bond that pays 5% generates equal interest income as a corporate bond that pays 7.46%, after taxes (assuming all else is equal).
Could a Muni be Right for You?Since munis generally offer lower yields than taxable securities, you need to determine whether there is enough tax savings to make it worth your investment. Non-profit organizations are almost always better off investing in corporate bonds, due to their tax-exempt status.
Individual municipal bonds are sold only in lots of $5,000 and are available through a stockbroker. Before making any decisions about municipal bonds, talk with your financial advisor to determine if or which muni option would be best.
Douglas T. Charney, a Senior Vice President –Investments with Wachovia Securities in Harrisburg, PA. For more information, please call him at 888-529-2973. Wachovia Securities, LLC.
Yields and market value will fluctuate so that your investment, if sold prior to maturity, may be worth more or less than it’s original cost.
Income is generally free form federal taxes and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT).
Insurance coverage applies to the timely payment of principle and interest only. It does not eliminate market risk.
The market value of zero coupon bonds fluctuates more with changes in market conditions than regular coupon bonds and, therefore, may not be suitable for all investors.
Examples presented are hypothetical and are provided for informational purposes only. They are not intended to represent any specific return, yield, or investment, nor is it indicative of future results.