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Do Municipal Bonds Have a Place in My Portfolio?
The interest municipal bonds pay usually is exempt from federal income tax.* That alone doesn't make a muni bond or muni bond fund right for everyone, but you may want to explore whether they make sense for your investment goals.
How Munis Work
Risks and Rewards
Are Munis for You?
Bonds or Bond Funds?
How Munis Work
When you invest in a muni bond, you're typically lending money to a state or local government to build:
- Roads
- Schools
- Water Systems
- Other Public Works Projects
In return, you expect regular interest payments plus your principal at an appointed time in the future, known as the maturity date.
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Risks and Rewards
The risks and rewards of municipal bonds are fundamentally the same as other types of bonds. Their value before maturity fluctuates with changes in interest rates. Because governments and government agencies issue them, municipal bonds are considered less risky than corporate bonds.
The tax-exempt income provided by municipal bonds makes them attractive to many investors, especially those in higher tax brackets.
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Are Munis for You?
Because the income they provide usually is exempt from federal income tax, municipal bonds tend to offer a lower yield than taxable bonds with similar maturities. To determine whether that lower yield is the better deal, you have to compare the taxable investment to the municipal bond's taxable-equivalent yield.
You can calculate the taxable-equivalent yield for a municipal bond by using your federal income tax rate and the municipal bond's yield.
For example, if you're in the 31% tax bracket and you purchase a municipal bond with a yield of 6%, you would calculate the taxable-equivalent yield as shown:
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Taxable-Equivalent Yield Calculation
This chart will help you compare taxable and tax-exempt
yields.
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Example
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1. Begin with the yield of the muni bond you
are considering:
(For example, assume the investment you are considering
has a yield of 6%.)
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6%
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÷
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2. Subtract your federal income tax rate from
1.00:
(For example, in the 31% bracket, subtract .31
from 1.00.)
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0.69
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=
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3. Calculate taxable equivalent yield:
(Divide answer in line 1 by answer in line 2.)
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8.70%
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In this example, a taxable investment would have to yield 8.70% to compare to a municipal bond's tax-exempt yield of 6%.
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Bonds or Bond Funds?
If you invest in municipal bonds, you'll have to decide whether to invest in individual bonds or bond funds.
- If you buy a specific municipal bond, its interest rate will be fixed. Interest payments are likely to be made to you semiannually. When your individual bond matures, your principal will be returned to you. By comparison, the yield on a muni bond fund generally fluctuates depending on market conditions and the maturities of the bonds held in the fund's portfolio. Muni bond funds typically have no maturity date and generally distribute income monthly, which can be a plus if you are seeking regular income from an investment.
- You generally can invest in individual municipal bonds through a broker, which means you'll pay commissions, and you typically must make a larger minimum investment than with a muni bond fund. Many muni bond funds are "no load," meaning no sales charges or commissions, and they often allow relatively low minimum investments.
- Like many securities, individual bonds are subject to certain risks. For example, there is the risk that the bond may be redeemed before the maturity date (call risk) or that the issuer of the bond may default on the loan (credit risk). Muni bond funds are diversified among many individual bonds and are managed by professional portfolio managers. This may help reduce some of the risk when compared with investing in individual bonds.
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Are muni bonds or muni bond funds a good fit for your portfolio? Before you decide, you may want to discuss your overall tax situation with your tax professional or financial planner.
*Interest on municipal bonds may be subject to state and local taxes, as well as the federal Alternative Minimum Tax.
This information is for educational purposes only and is not intended as investment advice.
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