Investing 101: Munis

(Tuesday is one of my favorite days of the week, or at least it has become so, because each Tuesday I get to write another Investing 101 post.  As we cover more and more possible investments, I’m starting to get a bit more esoteric with the chosen investment options.  Here, we’re going to look at municipal bonds, commonly known as munis.)

Q: What are munis?

A: Munis, or municipal bonds, are bonds issued by cities or states.  As with any bond, it’s a promise that the invested money will be returned along with an agreed upon interest payment.  Like Treasuries issued by the federal government, munis are a way for cities, counties and states to fund current expenditures by taking on debt and paying it back in the future.

Q: Why invest in munis as opposed to Treasuries, then?

A: Munis have one feature that makes them very attractive, particularly to high income investors: many are federal tax free.  In order to encourage investors to buy munis and help fund state and local projects and programs, the federal government has exempted some munis from federal taxation; all the profit you make from muni interest payments can not be touched by the IRS.  Furthermore, many states exempt munis issued within the state from the state income taxes as well, meaning that the interest from your muni could be free from state taxes as well.

Q: Wow, that’s great; but what’s the catch?

A: The ‘catch’ is that munis have lower yields than corresponding corporate bonds.  Thus, you might be better off financially by taking a higher yield corporate bond and using the profits to pay the needed taxes rather than going with the muni.  In general, if you are in a high tax bracket, muni bonds will be the best option for you; if you are in a low tax bracket, then taxable bonds will be better.

Q: That’s sort of vague; are there any firmer rules I could follow?

A: There’s a simple calculation you can use to make a decision between munis and taxable bonds into an apples-to-apples comparison.  If you take the yield of a municipal bond and divide by 1 minus your tax bracket (in decimal form), you’ll come up with number that you can compare directly to a taxable bond yield in order to choose the best investment for you.  For example, if you are in the 25% tax bracket and can invest in a municipal bond that yields 4%, the calculation would look like this:

(Muni Yield)/(1-Tax Bracket) = 4%/(1-0.25) = 4%/0.75 = 5.33%

Assuming you can find a corporate bond with a yield at or above 5.33%, that would be the smarter investment (assuming both the corporate bond and muni have the same rating and default risk, of course).  If not, the tax exempt nature of the muni will more than compensate for the lower yield, allowing you to come out ahead financially.  (All this assumes that you are investing in a taxable account; if you are investing in a tax-deferred or after tax account (such as a retirement or educational savings account), then the tax advantage of munis disappears and you can just compare the offered interest rates.  Of course, for straight interest rates, corporate bonds usually come out ahead.)

Q: Is there an easier way to invest in munis?

A: Just like with any type of bond, there are mutual funds that invest in purely in municipal bonds.  If you want the tax advantages offered by munis without the hassle of purchasing individual bonds (as well as diversification without having to buy dozens of different bonds), a muni bond fund could be the answer.  Of course, the unlike individual bonds, the yields on muni funds aren’t fixed, which could make it harder to determine whether the muni fund is a better value for your investment dollar.

If you do opt for a muni fund, you can find both general muni funds as well as state specific muni funds.  If you are looking at a mutual fund company such as Vanguard, you can find these funds by looking for the ‘tax-exempt’ title in the fund name or category.  You can find their long-term muni fund or if you are a fellow Pennsylvania resident, you could opt for the Pennsylvania muni fund and save even more in taxes, for example.

Q: Finally, how should I invest in munis or muni funds?

A: Basically, if you are looking to add some bond exposure to your taxable holdings, you can consider using munis for your bond allocation (assuming your tax bracket is high enough to make the lower but tax free return for munis to be worthwhile).  This is one way to manage your taxes and limit how much you will owe.  (Again, if you are investing in a tax advantaged account, munis will do you no good; a tax-free investment in a tax free account serves no purpose).  As with any bond investments, you want to increase your exposure as you get older, stabilizing your portfolio.  How much to hold at each age will depend on your risk tolerance as well as your plans for the future.

That’s about it for municipal bond investments; hopefully, you now have a better idea of just how ‘munis’ can fit into your investment goals and future plans.

2 Responses to Investing 101: Munis

  1. Nice overview on muni’s. They may not be the most exciting investment but they’re definitely a solid fixed income option. (Especially if your in a high tax bracket)

    -Gen Y Investor

    • Thanks for the compliment. Yes, munis aren’t going to be an exciting topic over cocktails at your next party, but they do serve a purpose in many portfolios. Particularly, as you said, if you find yourself trying to minimize your tax liability.

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