Although taxation is seen as a necessary evil, there are ways and means by which you can escape paying taxes for the income you earn. Investing in municipal bonds is one such avenue that many people go for when they are looking to make higher returns without taxation. Let us see more about what these investments are and how you can use them to your best advantage.
What Are Municipal Bonds?
Investments with a fixed income that deliver better returns when compared to a similar type of government issue bonds or taxable corporate bonds are termed as municipal bonds (munis). Here are some important facts about them:
- These are popular as federal taxes (and in a few cases even local) are not applicable for them.
- Munis are named so because they are issued by local or state municipalities.
- These are debt obligations with interest that a local or state municipality issues.
- Such bonds help fund expenditures such as public works or regular government requirements.
- Some top-performing bonds include:
- American High-Income Municipal Bond Fund
- Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares
- Some of the bad munis in recent times include:
- Vanguard Short-Term Tx- Ex (VWSTX)
- SEI Short Duration Municipal F (STET) (SUMAX)
How Do Municipal Bonds Work?
When you purchase munis, the following events unfold:
- You are lending funds to the institution that issues the bond in the expectation of being paid back at a particular date.
- The maturity date is the day when you get your funds back.
- Par or face value denotes funds you pay for the bonds on the issue date.
- Interest is paid on the munis by the issuing institutions to lure investors. This money is free from federal taxes and, in certain instances, from state and local taxation.
- Interest is paid bi-annually until the maturity date.
- The annual interest rate paid is called a coupon.
- The value of the bonds can increase or decrease based on the two factors:
- Economic situation
- Bond market conditions
- Yield to maturity (or just yield) is the name given to the interest on the bond price and duration until the maturity date. This is a significant factor as it helps evaluate the potential returns you get then with the interest rate or the coupon value.
2 Types Of Municipal Bonds
In general, munis are broadly divided into two types, which are explained here.
General Obligation Bonds
In this category, repayment of the bond money is assured by any possible means with complete credit and in good faith.
Here is what you should know about general obligation bonds:
- School districts, cities, towns, and states which depend on their local municipalities belong to the school district for assuring payment will get a large portion of funding from such bonds.
- Issuers, which are government institutions will be forced to pay back the money regardless of the circumstances.
- If they face any difficulty in paying the funds back, they have to use taxation in order to generate the funds required.
This category encompasses bonds that are paid back with the revenue earned from the various projects that the funds were used in. These imply a high default risk due to the following factors:
- While the issuing institutions are required to pay back the funds by whatever means, they may not generate the required cash.
- The paying ability for such bonds varies based on the issuing institutions. So, it is important to consider the institutions properly before investing in such bonds.
The rates are based on three significant factors:
- The interest rates are similar to yield values of Treasury bonds that have a lower risk than munis. But since the risk is higher, munis carry higher rates.
- The credit score of the municipality influences the rating. AAA is the highest value, which is considered the safest; hence, rates are lower. With a lower rate, the interest is higher. This is to compensate for the high default risk.
- Bond duration will influence the yield. For instance, bonds of more than ten years’ duration pay higher than those that are under ten years.
Pros And Cons Of Municipal Bonds
By knowing the good and bad points of such bonds, you can decide whether they are right for you or not.
- These are free of Federal taxation, and with the right type of munis, you can be exempt from the local and state taxes as well.
- Tax-free investment can compound growth faster when compared to a taxable investment.
- Volatility is low when compared to stocks, treasuries, or FDIC insured instruments.
- Liquidity is high with these bonds as secondary market trading is possible with them. When you need funds urgently, you can access penalty-free funds.
- Yield is very low for such bonds, and in case of inflation, they do not hold up well.
- For low tax level investors, the benefits of such bonds are less than those with a higher tax level. And such individuals can earn more returns on a taxable bond instead of the munis.
- If interest rates surge, the existing bonds lose their value as their low-interest rates force bondholders to sell them at discounted rates to level their value with the existing bond yields. This is particularly true when you want to cash out such bonds.
- Default risk is higher, and you stand to lose your capital in the event of the concerned municipality facing a financial downturn.
For individuals looking at instruments that have minimal tax and better returns, munis provide several benefits. But since they carry a certain amount of risk as with any other instrument, you need to be cautious while investing in such bonds. Diversifying your portfolio is a wise way to minimize your losses. This can be done by buying shares that are part of an inherently diversified fund of munis. Munis are ideal for those in a high tax layer and searching for low-risk and tax – free income to add to their existing portfolio.