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Municipal Bonds

By David Luhman on Mon, 05/11/2009 - 23:19

Municipal Bonds

How municipal bonds are different from other bonds

Types of municipal bonds

Who should consider buying municipal bonds

How to determine the equivalent yield on municipals

Are "double-exempt" bond funds better than "single-exempt" funds?

When to never invest in municipals

How municipal bonds are different from other bonds

Municipal bonds are offered by state and local governments

Municipal bonds offer something that US Treasury and corporate bonds can't

Interest payments are free from federal income tax

However, because of the tax-free nature of the interest, municipal bonds yield less than other bonds of comparable maturities and credit worthiness

Municipal bonds are also generally safer than corporate bonds since many municipal bonds are backed up by the local government's taxing authority

Types of municipal bonds

General obligation bonds are generally the safest form of municipal bond

  • The municipality can and must use its taxing authority to pay off the bonds
  • Used to fund infrastructure like sewers or to simply fund budget deficits

Revenue bonds are more speculative

  • Used to fund airports, stadiums and the like
  • Usage fees from these facilities are used to repay the bonds
  • If enough people don't use the facilities, the bondholders don't get paid

Private activity bonds

  • Used to fund projects with a commercial interest
  • May be subject to tax through the alternative minimum tax

Single-exempt bonds are issued by states or municipalities outside your state

Single-exempt bonds are exempt from federal income tax but subject to state income tax

Double-exempt bonds are issued by states or municipalities inside your state

Double-exempt bonds are exempt from federal income tax and state income tax

Only interest income on municipals is tax-free

Still have to pay capital gains

Higher income people who receive Social Security benefits face an indirect tax on their numicipal bond income

Who should consider buying municipal bonds

Remember that municipal bonds yield less than comparable bonds because of tax-exempt income

So only invest in municipal bonds if the after-tax yield is attractive for the maturity and degree of credit risk

This depends on your tax bracket

For single-exempt bonds, or if your state has no income tax, use your marginal federal income tax rate

Federal tax rates are 15, 28, 31, 36 and 39.6 percent

If you're in the 15 percent bracket, you probably shouldn't invest in municipal bonds

For double-exempt bonds, use your federal income tax bracket plus your state income tax bracket

State marginal income tax rates are typically 5 percent

How to determine the before-tax equivalent yield on municipals

The before-tax equivalent yield is the yield of a taxable bond such that you would be indifferent, on an after-tax basis, of buying the taxable or tax-free bond

Equavalent yield = (Quoted yield on municipal bond) / (1 - marginal tax rate)


Single-exempt bond, 28 percent federal tax bracket, bond yields 6 percent

Equivalent yield = 6 percent / ( 1 - .28) = 8.33 percent

At this tax bracket, you would be indifferent to buying a taxable bond yielding 8.33 percent and buying a municipal bond yielding 6 percent, if the maturity and credit risk were comparable

Double-exempt bond, 31 percent federal tax bracket, 5 percent state bracket, bond yields 7 percent

Equivalent yield = 7 percent / ( 1 - .36) = percent = 10.94 percent

Before-tax yield

After-tax equivalent yield for indicated tax bracket

15% bracket

28% bracket

33% bracket

36% bracket

3.0% 3.5% 4.2% 4.5% 4.7%
4.0 4.7 5.6 6.0 6.3
5.0 5.9 6.9 7.5 7.8
6.0 7.1 8.3 9.0 9.4
7.0 8.2 9.7 10.4 10.9
8.0 9.4 11.1 11.9 12.5

Are "double-exempt" bond funds better than "single-exempt" funds?

To create the greatest amount of tax avoidance, it's best to invest in double-exempt bonds

But buying individual bonds can be a hassle and expose yourself to risk because of lack of diversification

So you may want to invest in a double-exempt bond fund

Invest in a low-cost one like Vanguard California Tax-Free

But unless you can find a low-cost double-exempt municipal bond fund, you probably don't want to invest in double-exempt bond fund

Most double-exempt municipal bond funds are sold with high sales loads

The sales load usually eats up any advantage you gain from having a double-exempt bond

Here's a better strategy if you live in a small state where you can't find low-cost double-exempt bond funds

Satisfy yourself with the savings from investing in a low-cost single-exempt fund

Federal income tax rates are much higher than state-income tax rates

Or, if you have perhaps $100,000 or more to invest, create your own diversified portfolio of municipal bonds

Municipal bond mistake

Investing in a double-exempt fund in a state with no state income tax


Don't invest in a Texas double-exempt bond fund

No higher equivalent yield since no Texas income tax

Lack of diversification exposes you to risk if the Texas economy goes down

When to never invest in municipals

Never put municipal bonds inside of a retirement account

If you place municipal bonds in a retirement account, you'll get a low yield and no tax advantages

In fact you'll have to pay taxes later since all earnings on retirement account money are subject to taxation

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