Think Twice Before Buying Tax-Free Municipal Bonds

Investors favor municipal bonds, or "munis," for two main reasons. They are exempt from federal taxes, and they are relatively low-risk investments.

While stable, income-producing bonds warrant a position in any well-diversified portfolio, there are inherent drawbacks to owning munis. Individuals interested in purchasing them need to consider several factors before making muni bonds part of their investment strategy.

Key Takeaways

  • The interest you receive from muni bonds is free from federal taxes but there may be state or local taxes or both.
  • Beware: If you receive Social Security, your bond interest will be counted as income in calculating the taxable amount of your Social Security income. That could increase the amount you owe.
  • The interest rate paid on muni bonds is generally lower than rates for corporate bonds. You need to determine which deal has the better real return.
  • On the plus side, highly-rated municipal bonds are generally very safe investments compared to almost any other investment. The default rate is tiny.
  • As with any bond, there is interest rate risk. If your money is tied up for 10 or 20 years and interest rates rise, you'll be stuck with a poor performer.

Understanding Municipal Bonds

A municipal bond is a loan to a state or local government or an entity under its control. A government or agency might issue a bond to fund its routine expenses or to undertake a specific public project such as the construction of a bridge.

As with any bond, a muni is an investment in debt. The investor effectively lends a sum of money to a government or agency and is paid a regular stream of interest in return. At the end of a predetermined period of time, the investor's money is returned.

Why Investors Buy Bonds

Investors buy bonds in order to create a reliable stream of income (from the interest payments) while preserving their capital (since they're getting their money back in the end.)

Many investors devote a portion of their overall holdings to bonds in order to offset the greater risks inherent in almost any other type of investment, notably stocks. That is the purpose of diversification: Low-risk investments cushion potential losses from higher-risk investments. Even bonds are not risk-free. The risk is that the issuer will default on its debts.

Investors can judge the risk level of a bond they are considering by checking the bond's rating. All bonds sold in the U.S. are rated by one of three bond-rating agencies: Moody's Investors Service, S&P Global, or Fitch Ratings. Bond ratings are based on an analysis of the creditworthiness of their issuers.

How Municipal Bonds Differ

The big selling point of municipal bonds is their federal tax-free status. That is, the interest payments are not taxed at the federal level. Some states do not tax municipal bonds, but others do. It is, not surprisingly, complicated. Seven states have no income tax at all, so bond interest is a moot point. Other states don't tax in-state bonds but do tax out-of-state bonds in some circumstances.

There are a number of reasons to look carefully at municipal bonds before taking the plunge, and to compare them against other choices for investing your money:

  • Tax-free municipal bonds are not necessarily entirely free of taxes. As noted, there may be state income taxes on the interest. If you receive Social Security, your muni bond interest will count towards your adjusted gross income, thus potentially increasing the taxable amount of your Social Security income. Less commonly, there may be tax implications related to the de minimus tax and the alternative minimum tax.
  • Unless you just have an aversion to paying taxes, the point of tax-free municipal bonds is to improve the overall return on your money. Be careful that you don't choose an inferior return on your money in order to minimize your tax bill.
  • Municipal bonds, like all bonds, pose interest rate risk. The longer the term of the bond, the greater the risk. If interest rates rise during the term of your bond, you're losing out on a better rate.

Use the tax-equivalent-yield formula to compare the real return on a muni bond with a corporate bond.

The formula is: Tax Equivalent Yield = Tax-Free Yield / (1 – Tax Rate).

Translation: That's the yield that the muni must have in addition to its federal tax-free status to be equal to the yield of a corporate bond.

Comparing Real Returns of Muni Bonds vs. Corporate Bonds

Bonds used to fund local and state government projects like buildings and highways are afforded tax-exempt status at the federal level. Plus, people who purchase bonds issued by their states or localities may not be required to pay state or local taxes on the interest. That means some municipal issues have triple tax-free status. These tax advantages are offset by lower interest yields. Municipal bonds typically have lower coupon rates than similarly rated corporate issues with comparable maturities.

So, when considering munis, investors should compare the yields of taxable investment-grade and government bonds by using the tax-equivalent-yield formula. Tax-equivalent yield (TEY) is the yield that a taxable bond must have to equal or exceed the tax-adjusted yield of a municipal bond. Tax Equivalent Yield = Tax-Free Yield/(1 – Tax Rate). In general, higher-income investors (with theoretically higher tax bills) are likely to benefit more from municipal bonds than individuals in other tax brackets.

Interest Rate Risk

The risks of default by governments that issue muni bonds in the U.S. are low. However, bonds by definition have interest rate risk, which is important to investors who want to sell their bonds on the secondary market.

When interest rates fall, a long-term investor may even face risk to their principal investment. A bondholder selling a 30-year issue may receive less in principal than the bond initially cost.

Purchasing-Power Risk

Over the past decade, annual inflation in the United States has ranged between -0.7% (in 2015) to a projected high of 7% (in 2021). Otherwise, it was 2.3% or lower throughout that time. This means that a 20-year municipal bond that yields 2.5% to an investor in a 25% tax bracket, or a 3.3% tax-equivalent yield, would offer inflation-beating returns every year—right up until 2021, when it fails to get close to the rate of inflation.

Purchasing-power risk is the biggest potential drawback to investing money long-term in bonds. You'll get your money back in the end, but it may be worth less to you than it was. Investing solely in low-yielding municipal bonds is a safe approach but it could well mean giving up returns that exceed the rate of inflation and protect your purchasing power. A balance between municipal bonds and (relatively riskier) stocks can offset that risk.

Default Risk

Between 1970 and 2018, 0.16% of all municipal securities rated by Moody's Investor Service defaulted on their payments to investors. That's why muni bonds are considered a relatively safe investment.

The acid test of muni bond resiliency came with the COVID-19 pandemic as business activity ground to a halt and taxable receipts halted with it. Total defaults rose year-over-year to just 0.05% of the $3.9 trillion of municipal bonds outstanding.

Call Risk

A bond that is issued with a callable option adds another risk to the investor. It means that the issuer can cancel the issue, pay off the principal and stop the interest payments. The issuer wants that option, in case interest rates drop substantially, giving it the opportunity to issue a new bond at a lower interest rate.

Most municipal bonds are callable. Their investors will get their money back, but they'll have to find a new way to invest that money. A new investment in bonds will earn them less.

The alternative minimum tax can be a tax trap for muni bond investors who have very high income from tax-shielded sources.

Municipal Bond Tax Traps

As noted above, tax-free muni bonds are not always entirely tax-free. Bonds are particularly attractive to senior citizens seeking a steady stream of income for their retirement needs.

That makes Social Security income the most common pitfall for muni bond investors. Although the bonds are income-tax-free at the federal level, the income from muni bonds is counted towards the investor's adjusted gross income. A higher adjusted gross income can raise the portion of the taxpayer's Social Security income that is taxable.

High-income individuals also can run into the alternative minimum tax, which is aimed squarely at taxpayers with substantial income from tax-shielded sources.

How to Invest in Tax-Free Municipal Bond Funds

An investor can buy and sell bonds directly through an online brokerage account. They also can be purchased through a full-service brokerage or a bank.

Another option is to invest in an exchange-traded fund (ETF) or mutual fund that invests in muncipal bonds.

What Is the Average Rate of Return on a Tax-Free Municipal Bond?

In late 2021, interest rates were rising, and municipal bond rates were rising along with them.

As of July 10, 2022, 10-year AAA-rated muni bonds returned 2.60% compared to 2.70% a week earlier. A 20-year AAA-rated bond returned 2.90% compared to 3.00% the week before. A 30-year AAA-rated bond returned 3.05% compared to 3.15% the week before.

Can You Lose Money on Municipal Bonds?

You can lose the money you invest in municipal bonds if the issuer defaults. That risk is vanishingly small, considering that defaults on municipal bonds reached 0.05% of $3.9 trillion of outstanding debt in 2020, a time during which local tax revenues were decimated by the COVID-19 pandemic.

You also could lose money on muni bonds if you are forced to sell the bonds on the secondary market at the wrong time. The price you get will be determined by the total dollar amount of the remaining interest payments due, factoring in the prevailing rates available on new issues.

Which States and Cities Have the Best Municipal Bonds?

The best muni bonds from any issuer are rated AAA. They are issued by state and local governments nationwide and their bonds have been deemed AAA by one of the major rating agencies. When a government runs into economic trouble, its bond ratings suffer (but it also will pay a better interest rate in order to attract buyers).

After its 2013 bankruptcy, the city of Detroit missed payments on three of its general obligation bonds. That means it was responsible for three out of seven defaults on muni bonds rated by Moody's Investors in that year. The city has since managed to work its way back from a "negative" outlook to a "stable" outlook from S&P Global as of January 2021. Its outstanding debt was rated BB-.

A bond rated AAA or close to it is one of the best municipal bonds. A bond issued by a local government that is teetering on the brink of bankruptcy is one of the worst. Investors who don't care to keep an eye on the finances of state and local governments they invest in can invest in a bond mutual fund or ETF. It will be managed by someone who gets paid to pay attention to these things.

Are Municipal Bonds Safe?

A municipal bond, or any bond for that matter, is safe as long as its issuer does not financially collapse. Luckily, that's highly unlikely in the U.S. bond market.

The bond investor's best protection is to take care:

  • Check the bond rating. Defaults are rare, but they happen. A rating of AAA, AA, or A indicates an issuer that is on a sound financial footing.
  • Compare the real return on the municipal bond to other options for your money. It's always nice to save money on taxes but not at the cost of a better return for a comparable risk elsewhere, such as in high-quality corporate bonds.

The Bottom Line

Municipal or corporate bonds are a great alternative for investors who want to create a reliable stream of income, particularly during their retirement years. Highly-rated bonds are by their nature very safe investments compared to almost any other alternative and especially compared to stocks.

Municipal bonds are, as advertised, free of federal taxes. That doesn't mean that the overall return on a muni bond will be the best available option for you. You still have to do your due diligence to choose the best municipal or corporate bonds for you or the best mix of the two. Another alternative is to invest in a bond ETF or mutual fund and let someone else make the choices.

Article Sources
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  2. Municipal Bonds. "Are Municipal Bonds Exempt From State Taxes?"

  3. Schwab. "Not Always Tax-Free: 7 Municipal Bond Tax Traps."

  4. Internal Revenue Service. "Publication 550 Cat. No. 15093R Investment Income and Expenses (Including Capital Gains and Losses)," Page 12.

  5. U.S. Securities and Exchange Commission. "Investor Bulletin: Fixed Income Investments — When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall."

  6. US Inflation Calculator. "Current US Inflation Rate: 2000-2021."

  7. Lord Abbott. "Municipal Bond Defaults and Lessons Learned in 2020."

  8. Internal Revenue Service. "Retirement Benefits."

  9. Internal Revenue Service. "About Form 6251, Alternative Minimum Tax."

  10. FMS Bonds Inc. "Municipal Market Yields."

  11. Reuters. "Detroit leads 2013 U.S. bond defaults: Moody's."

  12. The Detroit News. "City of Detroit maintains positive marks among bond rating agencies."

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