Should you be investing in Municipal Bonds?

Written by: Michael Carbone, CFP®

I think a lot of people wonder if they should be investing in municipal bonds or “munis”. The answer to this question is, it depends. So, let’s start from the beginning – what is a “muni” bond?

From the investor’s perspective, a municipal bond investment is made by lending money to a state, city, county, etc. that they’ll use to pay for a public project(s) e.g., building a new school, bridge, or highway, etc.

In return for lending the money, the muni investor is compensated through interest payments. So, what makes a muni bond different than other bonds like a C.D. or Treasury? Muni interest is generally tax-free. Sound’s great, what’s the catch? Muni bonds generally offer lower yields (compared to similar, non-muni bonds)

This brings us back to the original question, should you invest in municipal bonds? A good place to start is to determine if the tax-savings are greater than the lower relative yield. You can do so by calculating a tax-equivalent yield, or TEY. The formula is TEY= yield / (1-tax rate).

For example…

Let’s assume you pay income taxes at 22% marginal fed rate and 5% at the state level.

• You’re considering two potential bond investments:
  • A 5-year muni bond yielding 1% that is tax-free at both the fed and state level.
  • and a 5-year bank C.D yielding 1.5% that is taxable as ordinary income.
    • In this case, the tax-equivalent yield for the muni would be 1.37%, which is lower than the CDs 1.5% yield…

1. Now let’s assume the investor has a high-income level paying taxes at the 37% fed margin, 5% state, and a net investment income tax of 3.8% (45.8% total)
   • In this case, the tax-equivalent yield on the same muni would be 1.85%, which is higher than the 1.5% offered by the CD.

As you can see, the higher your tax rate, the more attractive a muni will be.

Please note: This is a hypothetical example for illustration purpose only and does not represent an actual investment.

Now that you have a starting point, I suggest educating yourself on other important considerations for investing in muni bonds. To name a few:

1. How risky is the bonds credit?
   1. I suggest researching General Obligation vs. Revenue Bonds
   2. The municipalities credit is also important. Think of the demographic – the workforce, unemployment, income levels, etc.
   3. Is the bond backed by some sort of escrow account, etc.?
2. Are there embedded “options” in the bond (aka calls, etc.), and how do they work?
   1. In my experience, more munis than not have embedded options.
3. Could a municipal bond investment introduce unwanted liabilities for you e.g., AMT tax, incremental S.S. taxes., etc.
4. How sensitive will the bond be to changes in market yields?
5. How does the investment fit into your overall portfolio?

If you don’t feel comfortable, or simply aren’t interested in doing this on your own, please reach out to me for a discussion. I’m happy to answer any questions you may have and/or show you how we’re helping investors. I can be reached by email or phone at Michael.carbone@raymondjames.com; 978.455.7799.

Thank you for reading!

Michael Carbone, CFP®

Important Disclosures

Securities offered through Raymond James Financial Services, Inc. Member FINRA/SIPC. Investment advisory services are offered through Raymond James Financial Advisors, Inc. Eppolito Financial Strategies, LLC is not a registered broker/dealer and is independent of Raymond James Financial Services.

Any opinions are those of Michael Carbone and not necessarily those of Raymond James.  Expressions of opinion are as of this date and are subject to change.  Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investments mentioned may not be suitable for all investors.  The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation.

Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.

Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Municipal bond interest is not subject to federal income tax but may be subject to AMT, state or local taxes.

Past performance is not indicative of future results and there is no assurance that any investment strategy will be successful.

Financial and investment planning inherently involve potential tax and legal implications, with which we are generally familiar.  We do not, however, practice as lawyers or CPAs and cannot give specific legal or tax advice.  You should always consult with your tax advisor, or your attorney, when making legal or tax decisions, however, we’re glad to work with your tax or legal professional to help you meet your financial goals. Raymond James and its advisors do not offer tax or legal advice.

U.S. Government Bonds and Treasury Bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value.

CDs are insured by the FDIC and offer a fixed rate of return, whereas the return and principal value of investment securities fluctuate with changes in market conditions.