By Joel Dansby* on Sep 29, 2020
Over the past few years, municipal bonds may have fallen out of favor due to the fact that, until recently, the returns in the stock and bond markets were generating steady returns. Now, with the market continuing its wild gyrations, and the bond market hanging on the edge of uncertain fed policies, investor attention has shifted to tax free municipal bonds as a haven for money in search of reliable returns. And, with the recent increase of the top income tax rate, investors are, once again, recognizing the value of tax free returns.
Municipal Bond Yields are Competitive Again
Generally, the benchmark for comparing municipal bond yields has historically been the 10-year Treasury rate. Since the 2008 financial crisis, the ratio of municipal bond yields to Treasury yields has been creeping towards parity, with many AA and AAA rated bonds reaching 80 to 100 percent of the Treasury bond yield. When you consider the tax-free component of the bond income, many municipal bonds offer higher tax-equivalent yields than Treasury bonds for investors in higher tax brackets.
The More Taxes you Owe the More you Save
Generally, if your income falls within the higher income tax brackets, you can benefit more from tax free bonds even thought their stated yields are lower than taxable corporate or government bonds. For instance, if you are in the 39.6% tax bracket, a 3% yield earned on a tax free bond would be the same as if you received a 4.2 % return from a taxable bond. If your combined state and federal tax bracket is higher, your equivalent tax free return would be even higher (municipal bonds are only state tax exempt if they are issued within your resident state).
Go for Quality….
The biggest issue with tax free bonds these days is the financial quality of their issuer. Many municipalities and states are under fiscal siege, and, in some cases, their credit ratings have been cut by the ratings agencies. It would be important to restrict your investment to the highest quality bonds that continue to earn a triple-A rating by Standard & Poor’s or Moody’s. Ratings down to “A” or “A1” could be considered high quality, and offer slightly higher yields than triple-A rated bonds, but it would be important to do some deep research into the fiscal soundness of the issuer.
Or, Go for Yield
If you are willing to assume more risk, and you are able to do some research on local government fiscal strength, you can increase your yield significantly by investing in tax free bonds issued with lower quality ratings. In the past, general obligation bonds issued by states were considered to be among the safest investments you could make. However, with some states in economic decline, you will need to exercise a high degree of “caveat emptor” – buyer beware.
Be sure to Diversify
Tax free municipal bonds can be purchased direct from an issuer or on the open market. They are typically sold or traded in denominations of $5,000. It is always advisable to include more than a couple of issues in your portfolio in order to achieve some diversification. For smaller investors, with under $50,000 of funds to invest, the better alternative might be with tax free municipal bond mutual funds that is comprised of a large portfolio of municipal and state bonds. You can find several high quality, well-managed municipal bond mutual funds that generate decent tax-free returns (they may not be state tax free) with very low expense ratios below .50%.
As with any investment that involved tax issues, it is always advisable to seek the guidance of a tax professional before investing any money. It is also recommended that you work with a qualified financial professional with experience in tax free bonds.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2023 Advisor Websites.