The primary advantages attracting an investor to Treasury bills or money market mutual funds are their liquidity and safety. But there is another significant benefit offered by particular money market instruments known as "munis," or short-term municipal securities: federal tax savings, which are particularly beneficial to those who fall within a high federal tax bracket.

Munis Defined

Municipal securities are interest-paying debt securities that state and municipal governments issue to finance operating expenditures, to fund certain tax-exempt entities including colleges and nonprofit hospitals, and occasionally to provide funds to firms and individuals. The tax-exempt status of munis not only relieves buyers from paying tax on the interest income, but also allows the government issuers to borrow at favorable rates.

Municipal securities are generically categorized as short-term investments; however, they are only technically short term if they have maturities of less than three years. Within the universe of short-term munis there are several categories of notes, including bond anticipation notes, tax anticipation notes, and revenue anticipation notes. The key word in all three is "anticipation," which refers to how the notes provide immediate, short-term funds that help bridge any financial gaps until the government receives proceeds from bond issues, taxes, or government sponsored revenue-producing projects. (For further reading, see The Basics Of Municipal Bonds.)

In the universe of longer-term munis are tax-exempt commercial papers and variable-rate demand obligations, which allow state and municipal governments to fund their large, long-term projects at short-term rates. Three additional types of long-term munis are swaps, municipal preferred stock, and floaters/inverse floaters, all of which enable issuers to borrow at long-term fixed rates, while providing investors with floating rate, short-term debt.

Individual Tax Rates
An investor would purchase munis only if he or she had a heavy enough marginal federal tax to seek protection from it. Munis offer lower yields than other taxable securities, so the investor must determine whether his or her tax savings are significant enough to make up for the lower yield.

The yields on munis are therefore often articulated in terms of the taxable interest rate that would be required to provide the same after-tax interest rate. The formula for determining the equivalent taxable interest rate for munis is the following:

R(te) = R(tf) / (1 – t)

R(tf) = the rate paid on the tax-free muni
t = the investor's marginal tax rate
R(te) = the taxable equivalent yield for the investor with a marginal tax rate of "t"

For example, say you have a marginal tax rate (t) of 25%, and you are considering a tax-exempt muni that pays 5%. Here is the calculation of the muni's after-tax interest rate:

R(te) = 0.05 / (1 – 0.25)
R(te) = 0.067

To be more favorable than the muni, a taxable security would have to offer you a yield higher than 6.67%.

Additional Tax-Exempt Benefits
In addition to being exempt from federal income tax, the income from munis may also be exempt from state income tax if the investor purchases securities issued by his or her home state or by municipalities located in his or her home state. If the investor receives this double tax exemption, he or she uses a revised version of the above formula to calculate the equivalent taxable rate:

R(te) = R(tf) / (1 – [tF + tS(1 – tF])

tF = the marginal federal tax rate of the investor;
tS = the marginal state tax rate of the investor

Say everything is still the same as the above example, except that the muni offers you double tax exemption and that you have also a 10% state income tax rate:

R(te) = 0.05 / (1 – [0.25 + 0.10(1 – 0.25])
R(te) = 0.074

The equivalent taxable yield on the muni paying 5% is now 7.4%.

Investing in Munis
Individuals can purchase munis directly through a securities dealer, but the more popular way is through a tax-exempt money market fund. Money market mutual funds typically comprise very large pools of money market securities, perhaps only specific munis, a mix of a variety of munis or even a combination of munis and other money market instruments. (To learn more, check out Introduction To Money Market Mutual Funds and A Long-Term Mindset Meets Dreaded Capital Gains Tax.)

Downfalls of Munis
Since the income generated by munis is greatly influenced by taxation legislation, they are somewhat subject to the taxation philosophy of the government of the day. Prior to the 1980s, munis were extremely popular investments because wealthy individuals paid higher marginal tax rates at the time. The Economic Recovery Tax Act of 1981 lowered the highest marginal tax rate from 70% to 50%, and the Tax Reform Act of 1986 further reduced the top individual rate to 33%.

The reduction of marginal tax rates lessened the popularity of munis, which in turn forced governments to raise muni rates disproportionately higher than that of other taxable instruments. State and municipal governments thereby lost some of the benefits of the inexpensive debt financing they had previously enjoyed, and became less inclined to issue short-term municipal securities to fund various projects or ongoing operations.

Even if the cause and popularity of munis has diminished somewhat since their pre-1980s heyday, they still have an important place in the portfolios of certain investors. For wealthy investors, munis can lighten the taxation burden significantly, especially if the investor benefits from double tax-exemption. Short-term municipal securities can be a very attractive addition to a well-diversified portfolio, especially when the holder of the portfolio falls within the upper echelons of the federal marginal tax rate.

Related Articles
  1. Options & Futures

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  2. Mutual Funds & ETFs

    CSM: ProShares Large Cap Core Plus ETF

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  3. Mutual Funds & ETFs

    SPXU: ProShares UltraPro Short S&P500 ETF

    Find out information about the ProShares UltraPro Short S&P 500 exchange-traded fund, and learn detailed analysis of its characteristics and suitability.
  4. Mutual Funds & ETFs

    TZA: Direxion Small Cap Bear 3X ETF

    Find out more about the Direxion Daily Small Cap Bear 3X ETF, the characteristics of TZA and the suitability of the Direxion Daily Small Cap Bear 3X ETF.
  5. Mutual Funds & ETFs

    BIB: ProShares Ultra Nasdaq Biotechnology ETF

    Find out information about the ProShares Ultra Nasdaq Biotechnology exchange-traded fund, and learn detailed analysis of its characteristics and suitability.
  6. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  7. Bonds & Fixed Income

    Credit Default Swaps: An Introduction

    This derivative can help manage portfolio risk, but it isn't a simple vehicle.
  8. Economics

    Currency Swap Basics

    A currency swap involves two parties exchanging a notional principal and interest to gain exposure to a desired currency.
  9. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  10. Mutual Funds & ETFs

    The Risks of Investing in Inverse ETFs

    Discover analyses of the risks inherent to inverse exchange-traded funds (ETFs) that investors must understand before considering an investment in this type of ETF.
  1. If I have only a limited amount of time to study for the Series 6, what should I ...

    The Series 6 Investment Company and Variable Contracts Products Representative Qualification Examination is administered ... Read Full Answer >>
  2. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  3. What are the main risks associated with trading derivatives?

    The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>
  4. Should you calculate Value at Risk (VaR) for counterparty credit risk?

    Value at risk (VaR) calculations may be helpful for risk management when trading credit default swaps and other derivatives ... Read Full Answer >>
  5. For what financial instruments is a modified duration relevant?

    The modified duration is a formula used to calculate the percent change in the price of a financial instrument when there ... Read Full Answer >>
  6. What is the difference between derivatives and swaps?

    Derivatives are securities with prices dependent on one or multiple underlying assets. Common derivatives include forward ... Read Full Answer >>
Trading Center