For those seeking to enjoy the potential benefits of tax-advantaged investing, municipal bonds and municipal bond mutual funds are big draws. Their chief appeal: The interest payments that these fixed-income investments generate are typically exempt from federal taxes, so they can help an investor reduce income-tax bills.
This special treatment is extended to muni bond investors because the bonds are issued and backed by municipal and state governments seeking to raise capital for public projects, such as transportation infrastructure, schools, utilities, or other improvements. In contrast, income generated by corporate bonds is fully taxable because the capital is raised by a private company.
In addition, munis’ interest payments may also be exempt from state and often local taxes if the investor lives in the state or municipality that issued the bond. The potential for tax exemptions at multiple levels of government can be especially important for investors in high income tax brackets who take a bigger proportional tax hit on their investment income than those with lower incomes.
Tax changes focus new attention on municipal bonds
The appeal of muni bonds has been strong this year. Through August, investors added a net $63 billion to mutual funds that invest in munis, up from just $4 billion in all of 2018, according to the Investment Company Institute, a mutual fund industry organization.
What’s more, muni bonds’ 2019 performance has been relatively strong. Through September 10, the S&P Municipal Bond Index returned 6.8%, outpacing the index’s 4.5% average annual return over the 10-year period through that date.1
The recent influx of cash into muni bond funds can be traced in part to the 2017 Tax Cuts and Jobs Act. While the legislation reduced a majority of individuals’ income-tax payments, many residents of areas with high levels of state and local taxes found that their overall tax bills climbed as a result of a new restriction imposed on a key tax deduction. The law set a $10,000 cap on the amount of state and local tax (SALT) payments that taxpayers can deduct from their federal taxable income; previously, there was no limit on the deduction.
As a result, many residents in such high-tax states as California, New Jersey, and New York found they had a larger potential tax incentive to invest in munis than they had before the law’s approval. The potential tax benefit from muni investing can help blunt some of the impact of paying relatively high SALT while also seeing fewer benefits as a result of a deduction that’s now capped at $10,000.
No matter how an investor is faring under the tax law, a full understanding of the potential opportunities and risks involved in muni bond investing is critical, as is a grasp of munis’ unique features. Here are four things to know.
1 Muni bonds fall under two broad categories—The two basic types are general obligation bonds and revenue bonds. General obligation bonds, often called GO bonds, are issued by municipalities that pledge to repay investors using their broad power of taxation. Revenue bonds are backed by the revenue that a specific project is expected to generate, such as public highway tolls, airport expansions, or utility fees, to cover the costs of water or sewer projects. While GO bonds are generally considered to carry lower risks than revenue bonds, they’re not risk free; historically, there have been municipal bankruptcies and other instances in which local issuers have defaulted on their obligations to investors. Just like corporate borrowers, states and municipalities are rated for creditworthiness by independent ratings agencies, and muni issuers with lower ratings can expect to pay higher interest rates to borrow—resulting in higher yields to the investor—than more highly rated ones.
2 There’s an easy way to calculate munis’ potential tax benefits versus taxable bonds—For investors comparing the relative merits of taxable corporate bonds versus munis, a measure called tax-equivalent yield can be useful. This calculation attempts to show the pretax yield that a taxable bond would need to generate for its yield to be equal to that of a muni bond, while factoring in the muni’s potential tax benefits. Here’s a simplified example: If your income from a taxable bond would be taxed at a 25% rate based on your income-tax bracket, subtract that figure from 100% (or 1.0 for purposes of this calculation) to arrive at 75% (or 0.75). If a nontaxable bond has a hypothetical yield of 3.0% (or 3.0), the calculation would look like this: 3.0 ÷ 0.75 = 4.0. The takeaway: A taxable bond would need to have a yield of 4.0% to generate an equivalent yield of a muni bond with a 3.0% yield. The higher the tax rate paid by an investor, the greater the differential will be between the amount of pretax yield that a taxable bond would need to generate to be equivalent to a muni bond’s yield. Plenty of free online calculators can help measure tax-equivalent yields.
3 A muni bond’s income can be taxable in some instances—If an investor sells a muni bond before its maturity date—the point at which interest payments cease and the bond’s principal is fully repaid—and receives a price greater than the cost at which it was originally acquired, the gain will be subject to capital gains taxes. In addition, interest payments from a small minority of munis known as private-purpose bonds are taxable. A muni bond may be considered a private-purpose bond if more than 10% of its proceeds are designated for private, nongovernmental activities—say a sewer extension that benefits a new industrial plant or professional sports stadium. In such instances, interest payments are treated as taxable income unless the bonds are specifically exempted. The offering statement accompanying the bonds’ issuance should disclose any such taxable exposure. (One starting point for researching muni bond financial disclosures is a free service run by the Municipal Securities Rulemaking Board and called Emma, or Electronic Municipal Market Access. It’s available at emma.msrb.org. )
4 Consider muni bond funds rather than direct investment in munis—Given the potential risk mitigation role that muni bonds are intended to play in many diversified investment portfolios, any loss triggered by a bond issuer’s default—however rare—could be particularly painful if the investor’s holding in that bond issue was substantial. Such a risk is one reason why there may be advantages to investing in a muni bond mutual fund rather than holding an individual muni bond. It’s no simple task for an individual investor to research whether a bond is attractively priced relative to its credit risks and other potential pitfalls, such as rising interest rates or inflation. Bond funds typically hold diversified portfolios of hundreds of bonds. If just a single issuer defaults, the impact on the fund’s overall portfolio may likely be modest. The fund’s portfolio manager assesses factors such as credit risk and a host of other variables that the portfolio manager may believe haven’t been factored in by the broader market.
Whether a muni is owned directly or through a fund, it’s an investment that may offer significant tax advantages for income-focused investors in high tax brackets. However, munis do carry risks, and tax treatment of muni income can be complicated. As with any type of investment, a professional financial advisor may be able to provide valuable investment and tax assistance. The John Hancock Investment Management Tax Center also has a wealth of resources which may be useful, including a schedule of 2019 tax rates and limits, tax forms, and more.
1 S&P Dow Jones Indices, as of 9/9/19. The S&P Municipal Bond Index seeks to measure the performance of the U.S. municipal bond market.