Municipal Bonds: Benefits & Risks
Municipal bonds are debt securities that are issued by entities that serve a civic purpose such as the construction of a school, hospital, and highways. Unless specified, municipal bonds offer the investor interest that is exempt from federal taxes. Further, if an investor purchases a bond from their state of taxation, the bond income is exempt from state taxes as well. Let’s take a look at an example.
Here we can see the issuer of the 10-year bond is the University of Hawaii and the interest rate is 5% per year. This bond pays out every six months, as such, a $10,000 bond would pay out $250 on April 1st, and $250 on October 1st. If you were a state of Hawaii taxpayer you would not pay federal or state income tax on the interest payments. As such, if you are in a higher tax bracket, your relative benefit of the tax free income is greater.
We can compare this tax free return to a taxable return by computing the ‘taxable equivalent yield’. This is calculated by subtracting your marginal tax rate from 100% which we will call your ‘tax bracket reciprocal’ or ‘tbr’. You then divide the tax-free yield by the ‘tbr’. This will give you the yield you would need to receive on a taxable bond that would equate to the tax-free yield.
For example: Marginal tax rate= 35%
Tax-free yield= 2.0%
Taxable equivalent yield= 2.0% divided by (1-0.35) or 3.077%
In investing, the benefits should be compared to the risks. These are a few examples of things to evaluate with municipal bonds.
The credit risk- You are lending an issuer money, and they are obligated to pay you back at a predetermined date in the future & interest payments along the way. You should be comfortable that the issuer is able to do so. One fundamental credit analysis criteria is the evaluation of the security of bond payment and interest. In the bond example above, the official statement indicates that the security of the bond is backed by revenues from the University of Hawaii and the University Network. An analysis of their financials is necessary.
Lack of trading activity- Municipal bonds can be illiquid at times. It is a highly fragmented sector, and certain bonds do not trade daily, weekly, or even monthly. That being said, if you sell the bond before maturity, there may be a larger ‘spread’ or cost due to its illiquidity.
Call provisions and the ‘yield to call’- Many municipal bonds carry a provision that allows the issuer to ‘call’ or redeem the bonds before maturity. There is a predetermined date range in which the bonds can be called, and at a call price. You should be comfortable with the return of the bond should it be called. This is calculated as the yield to call.
Impact on Social Security income taxation- the IRS considers municipal bond income part of your “modified adjusted gross income” for determining if your benefits are taxable.
Alternative Minimum Tax- private activity bonds are those in which more than 10% of the proceeds of the issue are used for private business use & the security more than 10% of the proceeds of the bond are backed by property for a private use business. Some examples of private activity bonds are stadiums, hospitals, and housing projects. While the interest from these bonds are generally exempt from ordinary income taxes, the income is included in calculation of the AMT. If you are subject to AMT, the impact on the return calculation can be significant.
Cory Nakamura CFA, CFP®
Chief Investment Strategist and Financial Advisor
CFA Charterholder
CERTIFIED FINANCIAL PLANNER™ professional
Mosaic Pacific Investment Advisors, LLC is a Registered Investment Advisor in the state of Hawaii. This information is provided for general education and is not considered to be investment advice. Please contact your advisor for specific advice concerning your financial situation. Any rates or projections noted herein are for illustration purposes only and does not reflect current interest rates nor is a forecast of future returns or interest rates. Transactions requiring tax consideration should be reviewed carefully with your accountant or tax advisor. If you would like more information on our firm our ADV Part 2A (Brochure) is always available to you at no cost.
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