If a friend asks, “Are 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 because the correct answer depends on a host of factors specific to a person’s individual circumstances. Case in point: if an investor sits in the 35% income tax bracket and lives in a state with relatively high income tax rates, investing in municipal bonds will likely be a better option than taxable bonds. Contrarily: investors hovering in the 15% tax bracket range should probably steer clear of municipal bonds. (See also: How Are Municipal Bonds Taxed?)
Fortunately, the following tax-equivalent yield (TEY) formula can help determine if municipal bonds are right for you:
Tax − Equivalent Yield=(1 − Marginal Tax Rate)Tax − Exempt Yield
Putting this formula into practice, let's assume you're contemplating a tax-free bond 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%. In this scenario, a municipal bond with a 6% yield offers a better return than many taxable bonds with higher yields. Now let’s say you’re in the 15% tax bracket, where the formula would be as follows:
Tax − Equivalent Yield=(1 − .15)6
In this situation, a municipal bond with a 6% yield would not present a better investment opportunity because the tax-equivalent yield would be 7.06%
Municipal Bonds vs. CDs
Although CDs might appear to be a better option because they contain virtually no risk, there are downsides to these instruments. Namely: when interest rates dip to low rates, CDs struggle to outpace inflation. Therefore, when we’re heading for a deflationary environment, sitting on cash is a more viable option, since 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. (See also: CDs vs. Bonds: Which Is the Better Investment?)
In general, municipal bonds are more attractive to those in higher tax brackets thanks to the greater cost savings.
Risks and Rewards
The biggest risk with municipal bonds is default. Historically, municipal bonds have experienced low default rates. The 10-year average cumulative default rate for investment-grade municipal bonds through 2017 totaled only 1.23%, compared to corporate bonds at 7.10%. Simply put: common sense investing should help you steer clear of trouble.
Municipal bonds come in two forms: general obligation (GO) bonds and revenue bonds. The former is much safer because it uses taxes (primarily property taxes) to pay off its bonds. Contrarily, revenue bonds rely on revenue generation of a project in order to pay off the bonds, which means performance partly depends on economic conditions, making them riskier.
Your exposure to municipal bonds should depend on your economic situation, investment goals, and location, as some state and local municipal bonds are tax-free. Ideally, municipal bonds should be part of a well-diversified portfolio that could also include domestic and international stocks, real estate holdings, TIPS, corporate bonds, ETFs, and U.S. government bonds.
The Bottom Line
If you’re in a high tax bracket and you live in a high-income-tax state, you might want to consider putting more weight on low volatility, tax-efficient municipal bonds.