Municipal bonds are issued by state and local governments and offer investors regular interest payments and return of principal at maturity. The interest payments are generally exempt from federal income taxes and, in some cases, state and local income taxes.
Municipal bonds offer different levels of credit quality, similar to corporate bonds, however they are considered to be safer than corporate bonds, all things equal. This article references municipal bonds of the highest quality that carry an AAA investment rating and are as close to being “risk free” as possible.
Technically, a state or local government can default and, unlike the federal government, would be unable to print its own money and bail itself out if a default occurred. By only investing in AAA rated municipal debt, investors can sleep soundly knowing that the chances of a default are so small as to be virtually nonexistent.
There are two main types of municipal bonds, general obligation bonds and revenue bonds. A general obligation bond is issued to finance a municipality’s operating expenses and/or capital improvements. GO bonds are guaranteed by the issuing municipality and are supported by the issuer’s taxing power.
Revenue bonds are issued to finance a specific project, such as an airport or a bridge. Revenue bonds typically draw on the revenue generated by the project in order to finance the debt.
Revenue bonds generally are riskier than general obligation bonds since they are not backed by the issuing municipality. In other words, if the project fails, the municipality may cease paying interest and/or principal payments on these bonds, even if they are otherwise in sound financial shape. As a rule of thumb, investors should focus on general obligation bonds.
While interest rates have climbed over the past six months or so, they are still very low by historical standards. It is still difficult to find safe, guaranteed fixed income investments that offer attractive yields.
Now, however, AAA rated municipal bonds with maturities of 0-15 years are very appealing. Many of these bonds have after-tax yields of more than 4 percent.
Yields of 4 percent might not sound like much. However, remember that municipal bonds are exempt from federal taxation, which makes them appealing to higher income households (they may also be free from state and local income taxes as mentioned above, but that discussion is beyond the scope of this note).
As an example, let’s take a couple earning $73,801 to $148,850, which puts them in the 25 percent marginal tax bracket.
Let’s say they invest in a portfolio of AAA rated, investment grade municipal bonds that yield 4 percent. Since they will not be paying federal income tax on any interest income, this is the equivalent of receiving 5.33 percent on a taxable government or corporate bond.
A safe, guaranteed effective yield of 5.33 percent is very good by today’s standards, considering that 10-year treasury bonds yield approximately 3 percent and AAA corporate bonds of similar duration yield about 4 percent. Federal income taxes must be paid on these bonds, unless they are held in qualified accounts.
Municipal bonds are ideal for investors in a relatively higher tax bracket, at least 25 percent. They should also be willing to commit, at minimum $50,000, but preferably $100,000 or more of after-tax, nonqualified funds to this strategy (funds not in retirement vehicles or other tax-advantaged accounts).
This is because we suggest investing in individual bond issues and not municipal bond funds. An investor would not want to own just one or two bonds – regardless of the fact that they are AAA rated and investment grade, because he still needs geographic diversification.
Therefore, in order to get adequate diversification and good pricing, an investor should be prepared to put at least $10,000 in each bond among five different issuers (hence the $50,000 minimum suggested). Bond funds are ideal for investors with less than $50,000 since that is the best way for them to obtain adequate diversification among issuers.