If someone asked you, “Are municipal bonds a better investment than taxable bonds?” how would you answer?

If you said yes or no right off the bat, you might have done a disservice to the person asking. As is often the case, the answer depends on the person’s circumstances. For example, if the investor sits in the 35% income tax bracket and lives in a state with high income tax, it’s likely going to be beneficial to invest in municipal bonds as opposed to taxable bonds. However, if you’re in the 15% tax bracket, it doesn't make sense to invest in municipal bonds. (See also: Avoid Tricky Tax Issues on Municipal Bonds.)

There’s a simple formula to determine whether or not municipal bonds would be beneficial for you. (See also: Bond Basics: Introduction.)

Tax-Equivalent Yield

Otherwise known as TEY, tax-equivalent yield is used to determine the difference in potential return between municipal bonds and taxable bonds. The formula is as follows: Bond yield / (100% minus your tax rate). (See also: Why Retirees Can't Count on Muni Bonds.)

If this seems complicated, let’s simplify it. Say the yield on a municipal bond is 6% and you’re in the 35% tax bracket. TEY = 6% (this is the yield on the municipal bond) / (1 – 0.35). This comes to 9.23%. So 6% / 0.65 = 9.23%.

The point is that a municipal bond with a 6% yield will offer a better return than many taxable bonds with higher yields.

Now let’s say you’re in the 15% tax bracket. In this situation, a municipal bond with a 6% yield would not present a better investment opportunity because 6% / (1 – 0.15) = 7.06% 5 (or 6% / 0.85 = 7.06%).

Municipal Bonds vs. CDs

If you’re thinking CDs might be a better option, think again. CDs are appealing because they offer virtually no risk, but when interest rates are low, they have a very difficult time outpacing inflation. Whenever we are heading for a deflationary environment, sitting on cash wouldn’t be a bad option since your dollars will go further. When you’re in a CD, at least you’re generating some interest while waiting. However, on a historical basis, municipal bonds have outperformed CDs by a wide margin. (See also: CDs vs. Bonds: Which Is the Better Investment?)

Here is a good sample. Consider the chart below, which is based on a low-interest-rate environment and a 36.8% tax bracket (this rate includes the 3.8% surtax on net investment income that applies to taxpayers reporting more than $200,000 for single filers; $250,000 for married couples filing jointly and qualified widowers in modified adjusted gross income):  

 

CD

Municipal Bond

Initial Investment

$100,000

$7,000

Rate of Interest/Yield

0.22%

2.09%

Annual Income

$220

$146

Tax Bill

$81

$0

After-Tax Income

$139

$146

Remaining Investment Money

$0

$93,000

In general, municipal bonds are more attractive to those in higher tax brackets thanks to the greater cost savings. You probably know your own tax bracket, but here are the states that fall into the high-income-tax category: California, Illinois, Massachusetts, New Jersey, New York, Ohio and Pennsylvania. (See also: 7 States With No Income Tax.)

Risks and Rewards

The biggest risk with municipal bonds is default. Historically, the municipal bond default rate has been around a miniscule 0.10%, making it a very safe investment. However, the default rate in 2014 was 0.17%. This is still safe. As long as you use common sense, you should be able to steer clear of any trouble. Furthermore, the 0.17% default rate is still much lower than the default rate for corporate bonds, which is currently 1.90%. (See also: Corporate Bonds: An Introduction to Credit Risk.)

Municipal bonds come in two forms: general obligation bonds and revenue bonds. The former is much safer because it uses taxes (primarily property taxes) to pay off its bonds. Revenue bonds rely on revenue generation of a project to pay off the bonds, which means performance, in part, depends on economic conditions, which makes them riskier.

The potential for default is the biggest risk for municipal bonds, though only relative to historical default rates, which are very low. Another negative is a lack of liquidity—you can’t move your money in and out of the position. (See also: Tax-Free Muni Bonds ETFs.)

Municipal bonds shouldn’t be the only thing you invest in, but you shouldn't necessarily avoid them, either. Your exposure should depend on your economic situation, investment goals and location (are your state and local municipal bonds tax-free?). Ideally, municipal bonds should be part of a well-diversified portfolio that also includes stocks (domestic and international), real estate, TIPS, corporate bondsETFs and U.S. government bonds

The Bottom Line

If you’re in a high tax bracket and live in a high-income-tax state, then you might want to put more weight on municipal bonds—they’re tax efficient and offer low volatility. Remember that general obligation bonds are safer than revenue bonds. And remember to make sure that the municipal bond you want to invest in is tax-free. This is usually the case, but not always. (See also: Diversify With Municipal Bond ETFs.)

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