What Are Municipal Bonds?
Municipal bonds are bonds issued by city, county, and state governments to fund local projects such as highways, schools, and hospitals. There are two main types of municipal bonds: General Obligation and Revenue Bonds. General Obligation bond, which are backed by the issuers’ ability to tax, are typically used for projects such as schools, hospitals, and sewer systems. Revenue bonds are issued by special local and state entities, such as utility companies, to fund revenue-generating projects for the business.
The Tax Benefits of Municipal Bonds
Municipal bonds are quite beneficial as investment tools as the interest paid to investors is exempt from Federal taxes. Many municipal bonds are even exempt from state taxes if the investor resides within the state issuing the bond.
Are Municipal Bonds Right for Your Portfolio?
In order to decide whether or not municipal bonds should be a part of your larger fixed income portfolio, you can calculate what is called the Taxable Equivalent Yield. Because municipal bonds are exempt from Federal (and sometimes state) taxes, a fully-taxable corporate bond will have to maintain a higher yield to perform at the same level as similar municipal bonds. To find the Taxable Equivalent Yield, use the following formula:
Taxable Equivalent Yield = (Tax-Exempt Yield)/(1.00-Tax Bracket)
An Example
An investor in the 25% purchases a municipal bond that has a tax-exempt yield of 5%. The Taxable Equivalent Yield equals:
0.05/(1.00-0.25) = .0667 or 6.67%
Thus, a fully-taxable corporate bond will provide a greater return to this investor than this specific municipal bond if it has a yield of at least 6.67%.
Investing in Municipal Bonds – A Higher Degree of Safety
It should be noted that not all municipal bonds are created equal. While many municipal bonds have similar objectives, the region or city that is backing the bonds can vary greatly in economic robustness. Investors looking to at municipal bonds to their portfolio should understand the responsible party for servicing the bonds’ interest payments as well as the economic climate of the issuer. Things to look for when investing in municipal bonds include: a municipality population of at least 10,000, an economy that does not rely on one industry or sector, and a strong history of prompt payments on previous municipal bonds.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free, but other state and local taxes may apply.
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