Municipal Bond Investing

What is a Municipal Bond?

Municipal bond investing is a popular income choice for many Americans.  The muni bonds are debt securities issued by municipal authorities like States, Counties, Cities, and related businesses. Municipal bonds or “munis” are issued to fund general activities or capital projects like building schools, roads, hospitals, and sewer systems. The size of the muni bond market has reached 3.7 trillion dollars. There are about $350 billion of Muni bond issuance available every year.

To encourage Americans to invest in Municipal Bonds, US authorities had exempted the muni bonds’ interest (coupon income) from Federal taxes. In some cases, when the bondholders reside in the same state where the bond was issued, they can also be exempted from state taxes.

Types of Municipal Bonds

Municipal entities issue general obligation bonds to finance various public projects like roads, bridges, and parks. General obligation bonds are backed by the full faith and credit of the issuing municipality.  Usually, they do not have a dedicated revenue source. The local authorities commit their abundant resources to pay off the bonds. Municipals rely on their unlimited power to tax residents to pay back bondholders.

Revenue bonds are backed by income from a particular project or source. There is a wide diversity of types of revenue bonds, each with unique credit characteristics. Municipal entities frequently issue securities on behalf of borrowers such as water and sewer services, toll bridges, non-profit colleges, or hospitals. These underlying borrowers typically agree to repay the issuer, who pays the interest and principal on the securities solely from the revenue provided by the conduit borrower.

Taxable Bonds. There is a smaller but growing niche of taxable municipal bonds. These bonds exist because the federal government will not subsidize the financing of certain activities, which do not significantly benefit the general public. Investor-led housing, local sports facilities, refunding of a refunded issue, and borrowing to replenish a municipality’s underfunded pension plan, Build America Bonds (BABs) are types of bond issues that are federally taxable. Taxable municipals offer higher yields than those of other taxable sectors, such as corporate or government agency bonds.

Investment and Tax Considerations

Tax-Exempt Status

With their tax-exempt status, muni bonds are a powerful tool to optimize your portfolio return on an after-tax basis.

Muni Tax Adjusted Yield

So why are certain investors flocking into buying muni bonds? Let’s have an example:

An individual investor with a 35% tax rate is considering an AA-rated corporate bond offering a 4% annual yield and an AA-rated municipal bond offering a 3% annual yield. All else equal, which investment will be more financially attractive?

Since the investors pays 35% on the received interest from the corporate bonds she will pay 1.4% of the 4% yield to taxes (4% x 0.35% = 1.4%) having an effective after-tax interest of 2.6% (4% – 1.4% = 2.6%). In other words, the investor will only be able to take 2.6% of the 4% as the remaining 1.4% will go for taxes. With the muni bond at 3% and no federal taxes, the investor will be better off buying the muni bond.

Another way to make the comparison is by adjusting the muni yield by the tax rate. Here is the formula.

Muni Tax Adjusted Yield = Muni Yield / (1 – tax rate) = 4% / (1 – 0.35%) = 4.615%

The result provides the tax-adjusted interest of the muni bond as if it was a regular taxable bond. In this case, the muni bond has 4.615% tax-adjusted interest, which is higher than the 4% offered by the corporate bond.

 The effective state tax rate

Another consideration for municipal bond investors is the state tax rate. Most in-state municipal bonds are exempt from state taxes, while out-of-state bonds are taxable at the state tax level. Investors from states with higher state tax rates will be interested in comparing the yields of both in and out-of-state bonds to achieve the highest after-tax net return. Since under federal tax law, taxes paid at the state level are deductible on a federal income tax return, investors should, in fact, consider their effective state tax rate instead of their actual tax rate. The formula is:

Effective state tax rate = State Income Tax rate x (1 – Federal Income Tax Rate)

Example, if an investor resides in a state with 9% state tax and has 35% federal tax rate, what is the effective tax rate:

Effective state tax rate = 9% x (1 – .35) = 5.85%

If that same investor is comparing two in- and out-of-state bonds, all else equal, she is more likely to pick the bond with the highest yield on net tax bases.

AMT status

One important consideration when purchasing muni bonds is their Alternative Minimum Tax (AMT) status. The most municipal bond will be AMT-free. However, the interest from private activity bonds, which are issued to fund stadiums, hospitals, and housing projects, is included in the AMT calculation. If an investor is subject to AMT, the bond interest income could be taxable at a rate of 28%.

Social Security Benefits

If investors receive Medicare and Social Security benefits, their municipal bond tax-free interest could be taxable. The IRS considers the muni bond interest as part of the “modified adjusted gross income” for determining how much of their Social Security benefits, if any, are taxable. For instance, if a couple earns half of their Social Security benefits plus other income, including tax-exempt muni bond interest, above $44,000 ($34,000 for single filers), up to 85% of their Social Security benefits are taxable.

Diversification

Muni bonds are a good choice to boost diversification to the investment portfolio.  Historically they have a very low correlation with the other asset classes. Therefore,  municipal bonds returns have observed a smaller impact by developments in the broader stock and bond markets.

For example, municipal bonds’ correlation to the stock market is at 0.03%. Their correlation to the 10-year Treasury is at 0.37%.

Interest Rate Risk

Municipal bonds are sensitive to interest rate fluctuations. There is an inverse relationship between bond prices and interest rates. As the rate goes up, muni bond prices will go down. And reversely, as the interest rates decline, the bond prices will rise. When you invest in muni bonds, you have to consider your overall interest rate sensitivity and risk tolerance.

Credit Risk

Like the corporate world, municipal bonds and bond issuers receive a credit rating from major credit agencies like Moody’s, S&P 500, and Fitch. The credit rating shows the ability of the municipality to pay off the issued debt. The bonds receive a rating between AAA and C, with AAA being the highest possible and C the lowest. BBB is the lowest investment-grade rating, while all issuance under BBB is known as high-yield or “junk” bonds. The major credit agencies have different methodologies to determine the credit rating of each issuance. However, historically the ratings tend to be similar.

Unlike corporations, which can go bankrupt and disappear, municipals cannot go away. They have to continue serving their constituents. Therefore, many defaults end up with debt restructuring followed by continued debt service. Between 1970 and 2014, there were 95 municipal defaults. The vast majority of them belong to housing and health care projects.

In general, many investors consider municipal debt to be less risky. The historical default rates among municipal issuances are a lot smaller than those for comparable corporate bonds.

Limited secondary market

The secondary market for municipal bonds sets a lot of limitations for the individual investor. While institutional investors dominate the primary market, the secondary market for municipal bonds offers limited investment inventory and real-time pricing. Municipal bonds are less liquid than Treasury and corporate bonds. Municipal bond investing tends to be part of a buy-and-hold strategy as most investors seek their tax-exempt coupon.

Fragmentation

The municipal bond market is very fragmented due to issuances by different states and local authorities. MUB, the largest Municipal ETF, holds 2,852 muni bonds with the highest individual bond weight at.45%. The top 5% holdings of the ETF make 1.84% of the total assets under management. For comparison, TLT, a 20-year old Treasury ETF, has 32 holdings with the largest individual weight at 8.88%. The top 5% make up 38.14% of the assets under management.

About Stoyan Panayotov

I am a fee-only financial advisor and the founder of Babylon Wealth Management. As fiduciary advisors, we provide bespoke wealth management and personalized financial planning to busy families in the Bay Area and nationally. Many of our clients are tech workers, physicians, business owners, professionals preparing for retirement and young families looking to build financial independence.

I started Babylon Wealth Management to help young families and successful professionals build, grow and preserve their wealth. Being a fee-only financial advisor, I never earn sales commissions or sell investment products. Furthermore, I am committed to acting in my clients’ best interest by providing trusted advice and bespoke wealth management solutions. I enjoy helping clients develop robust and personalized long-term financial plans to achieve their personal and financial goals.

After completing a bachelor’s degree in Accounting at Varna University of Economics in Bulgaria, at the age of 23, I moved to New York City to pursue a Master of Business Administration at Pace University. I was fortunate enough to have a full merit-based scholarship and finished graduate school with no student loans. Upon completing grad school, I joined the ranks on Wall Street for nearly two years. I specialized in risk management and option strategies for equity and fixed income products for Deutsche Bank and Wells Fargo. In 2006 I obtained a highly recognized CFA designation.

Living in New York without family support was a life-changing experience for me. II arrived at JFK Airport on August 24, 2002. I stayed in a hostel for two weeks and later moved in with three of my fellow Bulgarian students into a one-bedroom apartment in the Bronx. There was a time in life when all I owned was $200, just enough to pay for the next month’s rent. Many times, I contemplated returning to Bulgaria, but somehow, I always pushed through life’s adversities. I’ve learned to appreciate each moment, big or small, that life presents. These challenges have helped me develop strength and flexibility, which supports my practice as a financial advisor.

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