Investors favor municipal bonds for a variety of reasons. The most appealing features of bonds issued by states and municipalities are their federal tax-exempt status and their positioning toward the lower end of the risk spectrum. While stable, income-producing, debt issues seem to warrant a position in anyone’s portfolio, there are inherent drawbacks to owning munis. Individuals interested in purchasing these bonds might want to consider several factors before making tax-free issues part of their investment strategy.

Tax Bracket

The biggest plus to municipal-bond investing also turns out to be the one that requires the most scrutiny. Debt securities used to fund local and state government projects, such as buildings and highways, have long been afforded tax-exempt status at the federal level. Furthermore, residents who purchase bonds issued by their states or localities may not be required to pay the corresponding state or local taxes levied against nonresidents. Thus, certain municipal issues receive triple tax-free status.

Lower yields accompany tax advantages. Municipal securities typically hold lower coupon rates than similarly rated corporate issues with comparable maturities. For this reason, potential investors should compare the yields of taxable investment-grade or government bonds by using the tax-equivalent-yield formula. Tax-equivalent yield (TEY) is the yield that a taxable bond must hold to equal or exceed the tax-adjusted yield of a municipal bond. Tax Equivalent Yield = Tax-Free Yield/(1 – Tax Rate). Therefore, higher-income investors (with theoretically higher tax bills) are likely to benefit more from municipal bond yields than individuals in lower tax brackets.

Interest Rate Risk

With respect to principal, investment-grade municipal bonds tend to be stable. Since most issuers of tax-free debt have taxing authority, the risk of default among governmental entities is low. However, the principal of muni bonds is inversely proportionate to interest-rate movements, as with any other bond. Debt securities with longer maturities incur greater fluctuations in market value as interest rates rise or fall.

In low interest-rate environments, investors face risk to principal as rates gradually rise and principal declines. A bondholder wishing to sell a 30-year issue in the secondary market may receive less in principal than was initially paid for the security. Despite the perceived notion of safety, investors may suffer a loss to principal if they sell a bond prior to maturity.

Purchasing-Power Risk

Municipal bond investments have their place, but investors must take into account the impact inflation has on real returns. Over the past decade, annual inflation in the United States has ranged between -0.4% (in 2009) to as high as 3.2% (in 2011). 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 attractive real returns in some years and barely keep pace with inflation in other years.

One of the main objectives for investors is that they do not outlive their nest egg. Investing solely in low-yielding municipal bonds, while a safe approach, forsakes growth alternatives that exceed average rates of inflation and do not erode purchasing power. An equitable balance between municipal bonds and (relatively riskier) equities may help offset the risks of eroding purchasing power.

Default Risk

The inability for a state or municipality to meet its debt obligations is rare. Between 1970 and 2018, 0.16% of all municipal securities rated by Moody's Investor Service defaulted. Municipal bonds that are insured come with an extra layer of protection, though just 5.6% of new municipal bonds issued in 2018 were insured, compared with 46.8% in 2007. To confirm the reality of this risk, investors can look to the debt crisis in Puerto Rico. In 2016, the territory defaulted on four bonds, affecting $22.6 billion in debt at the time. Puerto Rico has put forth a plan that would reduce $35 billion in bonds and other claims by more than 60%, representing a significant haircut for investors.