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Municipal Bonds: What You Need to Know

3753373323_04f8070888Municipal bonds are critical financing tools for state and local government entities.   But are they the right place for you to invest?

In addition to the income stream that municipal bonds generate is another benefit: they are tax advantaged.  For the vast majority of municipal bonds, interest received is not subject to federal tax.  Munis are the only security with that tax benefit (even Treasury securities are typically subject to federal tax).  And in most cases, if you live in the state or city issuing the bond, you may be exempt from state and /or city taxes as well.

Do the tax advantages of munis outweigh the often-lower yields they generate?  Would it be better to invest in a corporate bond with taxable interest?  Here’s a quick formula to answer that question:

  1. Add your federal, state, and any local income tax rates.
  2. Subtract the total from 1.00.
  3. Divide the remainder into the municipal bond’s current yield (if you’re buying it in the secondary market) or coupon (if it’s a new issue) to find the taxable equivalent yield.
  4. Compare the bond’s taxable equivalent yield to the current yield or coupon of the Taxable bond you’re comparing.

What to Be Aware of

Call risk – When a muni is callable, the issuer has the right to retire a bond before its maturity date.  The issuer might do that if the interest rate falls below a certain point (in effect refinancing the muni).  Many municipal bonds are callable.  If you’re looking to hold a bond to maturity, check out the call/redemption provisions listed in the bond’s Official Statement.

Liquidity risk – Municipal securities are typically less liquid than Treasuries.  While there is a secondary market for munis, it is typically more difficult to sell a municipal bond before its maturity, as most muni investors plan to hold the bond until maturity.

Credit risk — As with any bond, municipal bonds are guaranteed to return the principal at maturity – but only if the issuer remains solvent. Local government defaults are rare, but they do happen.  The city of Detroit, for example, filed for bankruptcy protection in 2013.  In 2008, Jefferson County, Alabama, defaulted on payments on $3.8 billion of sewer bonds.

Credit risk can be mitigated in two ways: First, by paying attention to the issuer’s credit rating.  All three major credit rating agencies – Standard & Poor’s, Moody’s, and Fitch – rate municipal bonds.  While the scales differ slightly among rating agencies, triple-A is the highest-rated muni bond, determined to be the least risky.  C- rated munis are deemed to be relatively high credit risks.

The second way to mitigate the risk of a default is to diversify your municipal bond holdings across regions.  While it’s generally true that when the national economy is doing well or poorly, state and local economies are, too, there are different patterns in regional business cycles.  Take advantage of those by diversifying across regions.

Photo Credit: hathu- via Compfight cc

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