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Investing in Municipal Bonds

Determining if Tax-Free Munis are Right for Your Portfolio

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Municipal bonds, or "munis" for short, are IOU's issued by city, county, and state governments in order to raise money for community projects such as a highway, new school, or hospital. Their primary attraction is that the interest paid to the owner of a municipal bond is exempt from Federal taxes. In most cases, an investor is exempt from state taxes as well if he resides within the same state in which the municipal bonds were issued.

General Obligation vs. Revenue Bonds

There are two types of municipal bonds. The first are called general obligation (GO for short), and are backed by the issuer's ability to tax. General obligation bonds are issued to pay for projects such schools and sewer systems. Most investors consider general obligation bonds safer than their revenue counterparts; this is a misconception.

Revenue munis, on the other hand, are issued by special state or local-government sanctioned entities (such as a utility company). The interest is serviced (i.e., paid) by the revenue generated from the business that backs the obligation. In the case of a water company, bond holders are paid out of the cash generated from customers paying their water bills.

Tax-Free Munis vs. Taxable Equivalent Yield

If you are an average investor interested in bonds, you may have a difficult time deciding between fully-taxable corporate bonds or tax-free municipals. Using a formula called taxable equivalent yield, you should be able to decide which type of fixed income investment will provide you the greatest after-tax return. Here's the formula you should use:

tax exempt yield
----(divided by)----
1 - tax bracket

An investor in the 15% tax bracket interested in a municipal bond that yields 5% would enter the following:

05 (tax exempt yield)
-------(divided by)--------
.85 (1 - .15 = .85)

The answer is 0.0588, or 5.88%. This means that if the investor could find a fully-taxable bond with a yield greater than 5.88%, he would earn more on his money by purchasing it rather than the tax-free municipal. Two rules of thumb:

  • Non-profit organizations are almost always better off investing in corporate bonds due to their tax free status.
  • Investors in high income brackets are almost always better off investing in tax-free municipal bonds.

Gauging the Safety of Municipal Bonds

There is very little information available concerning individual municipal bonds. This forces investors to rely heavily on the credit ratings assigned by various credit agencies. To help ensure the safety of their investment, bond holders should find out 1.) who is responsible for servicing the interest payments on the bonds, and 2.) the underlying economics of the issuer. Is it a blossoming community with a growing, high-net worth citizen base, or a deteriorating metropolis with lower-income demographics? All of these factors should be of concern. In the 1942 edition of Security Analysis, Benjamin Graham recommended municipal bonds possess the following characteristics:
  • Population of 10,000 or greater
  • Diverse economy
  • History of punctual payment on past obligations

More information

For more information, check out "The Bond Book" by Annette Thau. The book is designed for those with little or no bond experience and covers virtually everything an investor needs to know. I highly recommend it.

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