7 Things to Know About Tax-Free Municipal Bonds

Muni bonds can offer steady income and bring less risk.

Municipal bonds, or munis, are debt that is lent to a state, county or municipality and owning them can benefit investors in higher tax brackets. These bonds are backed by the full faith and credit of the government and are less risky than corporate bonds since a company could miss earnings, incur large losses and potentially default. Investors who are interested in preserving capital and generating tax-free income might find that municipal bonds are a good investment, says Stuart Michelson, a finance professor at Stetson University. “Muni bonds tend to be lower risk than other varieties of bonds,” he says. “Muni bonds are debt issued by governments, and similar to other bonds, they pay regular interest payments and return your original investment at maturity.” Here are seven things you should know about tax-free municipal bonds.

Muni bonds can be taxable and tax-exempt.

Muni bonds are either taxable or tax-exempt from federal, state and local income taxes. The tax-exempt munis are the most popular type with investors, Michelson says. There are several kinds of municipal bonds available to investors, with a variety of tax structures and funding sources, says Steven Levine, senior market analyst at Interactive Brokers, a brokerage in Greenwich, Connecticut. “Tax-exempt municipal bond issuance typically benefits investors who are in higher income tax brackets,” he says. “However, while municipal securities are generally not subject to federal tax, a capital gain from a sale or redemption would face taxation and typically be reported as ordinary income.”

There are two types of muni bonds.

Muni bonds are either general obligation bonds or revenue bonds. General obligation bonds are issued to raise funds immediately and are covered by general tax revenue such as an increase in property or hotel taxes, while revenue bonds are issued to finance infrastructure projects and are supported by the income generated by those projects, Michelson says. Residents typically vote on larger issuances of muni bonds such as school bonds when several schools will be constructed over a few years. Many muni bonds are callable, where the issuer or the government entity “calls” the bond and retires the debt before it matures. Muni bonds are subject to similar market risk like corporate bonds — bond prices react inversely to interest rate movement.

Muni bond yields are higher than U.S. Treasurys.

Another advantage of muni bonds is that they often generate higher returns than Treasurys. Investors seeking a steady income and less volatility often turn to muni bonds and Treasurys. Municipal securities have been recently trading rich compared to Treasurys, Levine says. High-yield municipal bond returns are up around 1.5% year to date and have generally outperformed many other fixed-income asset classes such as investment-grade corporate bonds which have gone down 5.3% year to date. The returns on Treasurys are down around 4% year to date, and mortgage-backed securities are down around 1.9% year to date. “However, many analysts think any rise or spike higher in U.S. interest rates will likely spur volatility in the municipal bond market and prices could fall,” he says.

Muni bonds have ESG options.

Investors who want to focus on environmental, social and governance — or ESG — practices may find a growing number of municipal bonds that plan to use the proceeds of their sale to fund eligible green projects, Levine says. For example, New Jersey Resources (ticker: NJR) sold $120 million worth of green bonds to help finance certain green investments, including NJR’s commercial solar projects. The bonds were offered with an annual fixed rate of 3.13%, maturing on Sept. 1, 2031. In 2019, NJR issued its first green bond for $150 million, and the net proceeds were used to finance eight commercial solar installations.

Muni bonds should be in a taxable account.

Muni bonds should only be held in a taxable account since tax-exempt retirement accounts like 401(k)s and individual retirement accounts “won’t get any benefit from the tax advantages that municipal bonds offer,” says Jodie Gunzberg, managing director and chief investment strategist at Morgan Stanley Wealth Management Institutional. Since income from these bonds is exempt from federal income tax, municipal bonds may provide a higher after-tax return than an alternative investment with taxable income, says Robert Johnson, a finance professor at Creighton University. A tax-exempt yield of 3% is equivalent to a 4.76% taxable yield, assuming the investor is in a 37% tax bracket, he says. “Of course, the higher an investor’s tax bracket, the greater the advantage of tax-exempt income,” Johnson says. “For instance, if the investor was in a 22% rather than the 37% bracket, a tax-exempt yield of 3% would be equivalent to only a 3.85% taxable income.”

Muni bonds are less liquid.

Municipal bonds are less liquid than their taxable counterparts since most are held by retail investors and often don’t have re-trade opportunities, Gunzberg says. “Additionally, the issue size of a municipal bond security is typically much smaller than taxable bonds which leads to lower liquidity,” she says. Since the fixed-income market can be “relatively opaque and individual municipalities can have unique influencing factors, seeking out a muni bond fund can help take some of the heavy lifting out of bond selection,” says Mike Loewengart, managing director of investment strategy at E-Trade. “Weigh the fees versus the return before committing to a fund,” he says. “With generally lower returns, fees can play a big factor here.”

Politics can influence muni bonds.

Under President Joe Biden’s administration, muni bonds could become even more attractive as cities and states that have been “hard hit by the pandemic could see an increase in aid, which may help shore up the finances of some muni issuers,” Loewengart says. Municipal bond investors also face increasing political and governance risk, including unfunded pension liabilities such as Kentucky, as well as imprudent fiscal policy or budget management, Levine says. New York state’s budget, for example, has grown by a compound annual growth rate of roughly 6% over 40 years to 2018, while its population has risen by only about a 0.25% compound annual growth rate over the same period. “These types of risks are typically not addressed by credit ratings agencies or found in the issuer’s official statement, which makes keeping abreast of trusted/credible news outlets a critical part of conducting fundamental analysis,” he says.

Seven things to know about tax-free municipal bonds

— Muni bonds can be taxable and tax-exempt.

— There are two types of muni bonds.

— Muni bond yields are higher than U.S. Treasurys.

— Muni bonds have ESG options.

— Muni bonds should be in a taxable account.

— Muni bonds are less liquid.

— Politics can influence muni bonds.

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7 Things to Know About Tax-Free Municipal Bonds originally appeared on usnews.com

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