A Primer on Municipal Bonds

Has tax time left you straining for strategies to ease next year’s bite? Then you may want to consider one of the few investments outside of your retirement plan that offers a tax advantage: municipal bonds or funds that invest in them.

Many investors think of so-called "muni" bonds as conservative investments that offer poorer yields than taxable Treasury, mortgage-backed or corporate bonds. What many don’t realize, however, is that for investors in tax brackets from 28 percent on up, municipal bonds’ lower tax-free yields may provide more income after taxes than higher-yielding taxable bonds.*

The following questions and answers will help you learn more about municipal bonds and determine if they could be a wise investment for you.

Q. What are municipal bonds?
A. Municipal bonds are debt securities issued by states, counties, cities and school districts to raise money for projects that benefit the public. Interest paid on the bonds is exempted from federal taxes by Congress to encourage investment in such projects. In addition to the federal exemption, some state and local governments exempt muni bond interest for investors who live in the state where the bond is issued.

There are two basic types of municipal bonds: general obligation and revenue issues:

General obligation bonds, or G.O. bonds, are approved by local voters and backed by the full faith and credit of the issuing government. These are usually considered the safer of the two types because the issuer can, if necessary, use its taxing power to pay the bonds’ interest and principal.

Revenue bonds are backed by the revenue produced by the financed project – such as a hospital, highway, stadium, airport or public housing. This type may be considered slightly riskier because repayment relies on the health of the project and its revenues; the bonds are not considered an obligation of the local government and taxpayers. To compensate for this additional risk, the bonds often pay a slightly higher yield than G.O. bonds.

According to the Public Securities Association, approximately 40 percent of all new municipal bond issues are insured, with scheduled interest and principal guaranteed by one of the several Triple-A municipal bond insurers. In addition, most issuers are evaluated by credit rating firms such as Moody’s Investors Service, Standard & Poor’s Corporation and Fitch Investors Service.

Q. In what form are municipal bonds issued?
A. Individual municipal bonds are generally sold in $5,000 units, with maturity ranging from one month to 30 years. If you invest in individual issues, it’s prudent to diversify your muni bond portfolio among several issues in different geographic regions. That means your minimum initial investment could be several thousand dollars.

You can also buy munis through a tax-exempt municipal bond mutual fund. With a fund, you’ll likely enjoy lower investment minimums and diversification across an entire pool of bonds, professional management and easy liquidity. To take advantage of triple tax exemption, buy shares of a bond fund that invests only in issues exempt from state and local taxes within your state of residence. (Certain income may be subject to the alternative minimum tax or state and local taxes.)

Q. Are munis right for me?
A. Municipal bonds may provide steady income and diversification to your portfolio, but you’ll probably want to consider them only if your tax rate is high enough to make them a better deal than taxable bonds.

For example, assume you are in the 36 percent federal tax bracket, have $30,000 to invest and are comparing a tax-exempt bond yielding 6 percent and a taxable corporate bond yielding 8 percent. If you buy the municipal bond you would earn $1,800 annually in interest, a 6 percent yield and pay no federal taxes. The 8 percent taxable bond investment, however, would provide you only $1,536 in income after $864 in federal income taxes have been deducted – a 5.1 percent after-tax yield. The muni bond would be an even better investment if you accounted for state and local income taxes when calculating returns on the taxable investment.

Q. Where can I obtain municipal bonds or a bond fund?
A. Investment firms, mutual fund companies, online brokerages and other outlets offer access to tax-exempt bonds and funds. Discuss your tax situation with a knowledgeable tax accountant. For guidance on selecting appropriate tax-exempt investments, talk with your financial advisor.

* Municipal bonds are subject to federal capital gains and losses — interest income is tax-exempt.