What Are Municipal Bonds?

tax free municipal bonds

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You’ve heard of stocks, bonds, and mutual funds, but what are municipal bonds exactly? Municipal bonds are also known as tax-free bonds, although they are sometimes redundantly referred to as tax-free municipal bonds.

They are debt securities offered by a state or local government. They are distinguished from sovereign bonds, which are issued by the federal government. Here, in the U.S., those are known as treasury bonds.

There are two fundamentally different kinds of securities with regard to returns: fixed-income and variable-income. Variable-income securities are tied to the stock market or the value of a company whereas the value of a fixed-income security is determined in advance. Government bodies under the sovereign level issue tax-free municipal bonds. A bond provides periodic payments with an eventual full return on investment once it reaches its maturity date.

Typically, bonds or stocks are used for a company to fund its growth. In the case of municipal bonds, the money is used to fund public projects like improvements to infrastructure. Tax-free municipal bonds are a popular choice among people in high-income tax brackets who want to shield their investments from taxes.

While tax-free municipal bonds are considered a safe bet, they are not entirely risk-free. For starters, an issuer may be unable to pay the periodic interest payments and the principal when the bond reaches maturity. Most issuers of municipal bonds have insurance that guarantees an investor’s principal.

In addition, the fact that they are issued by the government provides them with an added layer of security. Moreover, investors can check the credit worthiness of an issuer by looking at their rankings provided by ratings agencies.

Normally, the bonds that are most often discussed are those that are tax-free. The other kinds are taxable bonds. Tax-free municipal bonds are exempt from federal taxes, but their exemption from state and local taxes is contingent upon that area’s laws.

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Choosing Between Tax-Free Municipal Bonds and Taxable Bonds

Technically, “taxable municipal bond” is an incorrect term since a municipal bond by design is tax-exempt. Instead, it would be correct to just call it a taxable bond. Governments do issue bonds to raise capital in the same way private companies do. Tax-free municipal bonds (which can simply be called municipal bonds) are a way to do so with an added incentive.

Tax-free municipal bonds are issued when the profits are used to benefit the public interest. Improving infrastructure is a project that will benefit the public. A new research facility at a public university is something that can benefit the public.

However, if both are such conservative investment choices as fixed-income securities, why would anyone choose taxable bonds over tax-free municipal bonds? The answer depends on an individual’s financial situation.

A tax-free municipal bond is an attractive option, but the drawback is that it benefits from lower returns than a taxable bond. If you have a high annual income, the percentage you pay in taxes is significantly greater, and you have more incentive to shield your earnings. If you are from a lower tax bracket, you are not required to pay as much in taxes and, therefore, would stand to gain by getting a higher return and paying taxes.

Of course, there is a mathematical formula for determining whether you should invest in tax-free municipal bonds or taxable bonds based on your income. Calculating your tax-equivalent yield (TEY) allows you to determine the yield needed on a taxable return to make it equal to the yield gained from a municipal bond.

The Formula Is as Follows:

TEY = municipal bond yield/100% minus your marginal tax rate

For example, if the yield on your bond is 5% and you pay 35% of your income in taxes, your formula would look like this:

TEY = 5%/1-0.35 = 0.05/0.65 = 0.0769 = 7.69%

In this case, a taxable bond would have to give its investor a return of more than 7.69% to beat a tax-free municipal bond.

If you only paid 15% in taxes, the numbers would look much different.

TEY = 5%/1-0.15 = 0.05/0.85 = 0.0588 = 5.88%

A person in a lower tax bracket investing in the same bond would have to get a return of more than 5.88% in order for it to be more profitable than a tax-free municipal bond.

In this way, it makes more sense for a high-income individual to invest in tax-free municipal bonds than it does for a person with a lower income to do the same.

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The Risks Associated with Tax-Free Municipal Bonds

Bonds in general are considered a conservative investment vehicle compared to the volatility of stocks, but that does not mean they are risk-free. For starters, if you purchase a bond with a maturity date in five years and interest rates skyrocket, you are tied into the interest rate you originally agreed to. In addition, a change in your income could also be a risk factor. If you purchase tax-free municipal bonds because you have a higher income and then experience a significant decrease in your earnings, you may wind up in a situation where taxable bonds are more profitable.

The Different Kinds of Tax-Free Municipal Bonds

For some people, the fact that they are tax-free is as specialized as municipal bonds need to get. However, they do break down into further groups. There are two kinds of tax-free municipal bonds: general obligation bonds (GO) and revenue bonds.

A general obligation bond is a tax-free municipal bond used to cover expenses. They are backed and repaid by the power of the government body that issued it. Chiefly, it will be government revenue that pays the bond back along with the interest.

A revenue bond is a tax-free municipal bond that is directly tied to a specific project. For instance, if a local government sells bonds in order to fund a project like a new highway, the revenue from that new highway will be used to pay lenders back.

The key difference between these two tax-free municipal bonds is that a general obligation bond can be paid off using a variety of revenue streams whereas a revenue bond is paid off with the revenue from a particular project. As a result, revenue bonds can’t be issued for schools since those are funded by taxpayer dollars. However, they can be issued to build a highway and toll bridge since the revenue gained from that project is from drivers.

So what is a tax-free municipal bond for governments? Mainly, it is a way for them to make money. Secondly, in the case of revenue bonds, it is a way for them to circumvent any spending or debt limits.

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Which Kind of Tax-Free Municipal Bond Is the Safer Investment?

Simply put, a general obligation bond is the safer tax-free municipal bond. This is because it has the full force of the government body, which can use the taxes it collects (or creates) to pay the bonds back.

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How Do You Buy Tax-Free Municipal Bonds?

Tax-free municipal bonds sound almost too good to be true, right? A fixed income that is virtually untaxed that serves the public interest. An investment vehicle like that can’t just be purchased in your local bank, right? Wrong.

Bonds can definitely be bought at banks. They can also be acquired through brokerages and bond dealers. Some savvy investors choose the do-it-yourself approach and purchase their tax-free municipal bonds through online brokerages.

Tax-free municipal bonds can either be bought in the primary market or the secondary market. The primary market is typically reserved for high-net-worth individuals who can participate in what is known as the retail order period. Bonds bought during this period are purchased at face value and do not carry any additional fees or a marked up price. This serves as a way to let individual retail investors get a share along with larger institutions.

Everyday investors typically buy bonds on the secondary market. They open trading accounts with a bank or, if they prefer a more hands-on approach, an online brokerage account. Some investors opt for a representative while others prefer to fly solo. On the secondary market, municipal bond rates have a marked up price so that the seller can realize a profit.

A Tax-Free Municipal Bond’s Interest Rate aka Coupon

When talking about municipal bond rates, interest is called something else entirely. The interest rate you are paid for loaning your money (aka purchasing a bond) is called the coupon.

A tax-free municipal bond’s coupon will depend on the creditworthiness of the issuer. The lower the issuer’s bond rating, the higher the interest rate will be in order to make it worth it for the lender. Then again, it’s important not to let the allure of a high interest rate tempt you to purchase bonds from an issuer with a low credit rating. They have that rating for a reason, which is that they haven’t had the most stellar record.

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Incorporating Tax-Free Municipal Bonds into Your Investment Portfolio

Traditionally, bonds have been considered the safe bet and, as a result, the boring choice. Its more glamorous cousin, stocks, is spoken of way more often. It dominates the news with regular coverage of market activity, and fortunes have been made and lost through trades and bets. In comparison, bonds, let alone tax-free municipal bonds, don’t seem as fun.

But what are municipal bonds if not another way individuals can diversify their investments? Governments benefit through them by gaining an additional revenue stream, and investors benefit through obtaining a tax-free and relatively safe investment vehicle.

The best bet is not in choosing between stocks or bonds but rather in balancing out the two. Bonds almost guarantee a safe fixed income but with a lower return on investment. Stocks hold the potential of rapid growth, but there is also the risk that an investor will lose it all.

Buying municipal bonds can be a good move for somebody with a short-term financial goal. For instance, if you are planning to go back to school in five years and need a safe investment strategy for your savings, it’s best to put your money in bonds as opposed to stocks. You simply cannot afford to lose your principal.

On the other hand, if you are starting on a long-term investment strategy from an early age, like retirement, then investing in stocks is a better idea. Your retirement is a long way away, so you can benefit from the superstar growth possible through investing in the stock market while also having decades before you retire to recover from any dramatic losses. When you begin to approach retirement, you can start to transition some of that equity towards safer investments like tax-free municipal bonds. 

The number of funding mechanisms our financial system has made possible can seem exciting and confusing all at once. There are a variety of investment vehicles that individuals can benefit from, whether they like the high stakes game of the stock market or are looking for the steady earnings of tax-free municipal bonds. The key is diversifying your investments and gaining a proper understanding of just what these securities can do.

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