If a friend asks, “Are tax-exempt municipal bonds a better investment than taxable bonds?,” and you immediately answer with a hard “yes” or “no,” you might be doing your pal a disservice. The correct answer depends on a host of factors specific to a person’s individual circumstances.
The most important of these relates to the size of your tax bill. If you sit in the 35% income tax bracket and live in a state with relatively high income tax rates, investing in municipal bonds (munis, for short) will likely be a better option than taxable bonds. Alternatively, if your income is in the 12% tax bracket, you may want to steer clear of municipal bonds.
- In general, tax-exempt municipal bonds (munis) are more attractive to those in higher tax brackets.
- To compare municipal bonds to taxable bonds, you need to determine the tax-equivalent yield of the muni.
- Though CDs carry less risk, municipal bonds have tended to outperform them.
How to Compare Municipal and Taxable Bonds
While your tax bracket can provide a rule of thumb when considering munis overall, you need to consider individual investment opportunities a little more closely. Specifically, you need to compare the return of the muni to that of a comparable taxable bond by determining its tax-equivalent yield. Also known as the “after-tax” yield, the tax-equivalent yield takes into account your current tax rate to determine whether an investment in a municipal bond is equivalent to a corresponding investment in a given taxable bond.
Fortunately, there’s a formula for that. It is:
Tax − Equivalent Yield=(1 − Marginal Tax Rate)Tax − Exempt Yield
Putting this formula into practice, let’s say you’re contemplating a tax-free muni with a 6% yield, and your marginal tax bracket is 35%. You would plug in the numbers as follows:
Tax − Equivalent Yield=(1 − .35)6
In this case your tax-equivalent yield would be 9.23%. This means that if equivalent taxable debt instruments are offering yields in the 7% to 8% range, your municipal bond with a 6% yield offers a better return (even though its nominal yield looks lower).
Now, let’s say you’re in the 12% tax bracket. The tax-equivalent yield would be 6.8% (6 ÷ [1-.12]). In this situation, a municipal bond with a 6% yield would not present a better investment opportunity than those taxable bonds yielding 7% or more.
Generally, municipal bonds’ after-tax yields exceed those of taxable bonds for anyone whose marginal tax rate is 24% or higher.
Municipal Bonds vs Corporate Bonds
Of course, return isn’t everything. Investors also have to consider the risk of default. Historically, municipal bonds have experienced low default rates. According to the Municipal Securities Rulemaking Board (MSRB), the 10-year average cumulative default rate for investment-grade municipal bonds through 2016 totaled only .18%, compared to 1.74% for corporate bonds.
Municipal bonds come in two forms: general obligation (GO) bonds and revenue bonds. Both are tax-exempt. Although the latter is far more common, the former is much safer. GO bonds use taxes (primarily property taxes) to pay bondholders interest and eventually pay back their principal. Revenue bonds rely on the revenues generated by a project in order to pay off bondholders, which means performance partly depends on economic conditions, making them riskier.
Municipal Bonds vs. CDs
Now that we’ve seen how to compare munis with taxable bonds, such as corporate bonds, let's take a look at how munis compare with certificates of deposit (CDs). Although CDs might appear to be a better option because they are FDIC-insured and therefore have virtually no risk, they do have downsides. One downside is that when interest rates dip, CDs struggle to outpace inflation. Therefore, when we’re heading for a deflationary environment, sitting on cash is a more viable option, as your dollars will go further. Of course, when you’re locked into a CD, you’re generating some interest while waiting—which is a good thing. However, municipal bonds have historically outperformed CDs by a wide margin.
The amount invested in muni funds in 2019, a record-breaking high, according to MunicipalBonds.com
The Bottom Line
Your exposure to tax-exempt municipal bonds should depend on your tax bracket, investment goals, and location. If you live in a high-income-tax state, locally issued munis will be triple tax-exempt—that is, free not only of federal taxes, but also of state and city/county taxes. Ideally, municipal bonds should be part of a well-diversified portfolio that could also include domestic and international stocks, real estate holdings, mutual funds and exchange-traded funds (ETFs), and even other debt instruments, such as U.S. government bonds, Treasury inflation-protected securities (TIPS), and corporate bonds.