When discussing investing, many thoughts center on the next hot stock or the latest S&P 500 Index moves. However, if clients are conservative or closer to retirement, fixed income or bonds become a key part of most investors’ allocations.
At their simplest, bonds are a fixed income instrument that represents a loan made by an investor to a borrower. Bonds are typically issued by corporations or government entities. They have a coupon rate, which is the interest rate that the issuer promises the investor on an annualized basis until the bond reaches maturity. At maturity, the issuer promises to return the principal to the investor.
Municipal bonds are a specific type of bond issued by state and local governments. Municipal bonds are also called munis or tax-exempt bonds. To benefit state and local governments that need to borrow, usually the interest on a muni bond is federally tax-free. Sometimes, if a municipal bond is issued in your state of residence, the interest can also be state tax-free.
There are generally two types of municipal bonds, general obligation (GO) or revenue bonds. General obligation bonds are backed by the issuer’s taxing power. Revenue bonds receive interest payments from the project that the bond funds. For instance, a turnpike revenue bond helps build the turnpike and then uses the tolls to pay back its investors. Revenue bonds are generally considered less secure than GO Bonds. Private activity bonds are municipals that are subject to federal income tax (as with any tax benefit, there are always exceptions). If a municipal bond will serve a public purpose, but will primarily benefit private interests, it will most likely not be federally tax-free. Examples of projects that may issue municipal bonds with federally taxable interest are housing, student loans and airports.
Due to munis’ tax-free status, their interest rates are lower than comparative (same maturity and quality) bonds’ taxable interest. Therefore, investors in higher tax-brackets will benefit from municipal bond interest more than those in a lower tax-bracket. To compare a taxable bond with a municipal bond, you must calculate its “tax equivalent yield.” This is because the interest may be lower on a municipal bond, but you may be able to keep more of the interest after-tax. You would buy municipal bonds in taxable accounts and never in retirement accounts, where the tax-advantage already exists.
Municipals are issued in denominations of $5,000 or multiples of $5,000. While tax-exempt bonds are backed by revenue or taxation from an entity, they still carry risk. As with other bonds, munis have interest rate risk, credit risk and reinvestment risk. Even with these risks, municipal bonds are considered safe investments. Since 1970, there has never been a AAA rated municipal bond to default. Moody’s, a bond rating agency, looked at every default from 1970-2011 and there was a total of 71 bond defaults over the past 41 years (based on bonds they rated). Overall, the default rate on municipal bonds are .03% or 3 out of 10,000. Moody’s denotes the recovery rate on defaulted municipals at 67 cents on the dollar compared to the average recovery rate on corporate bonds in default, which is 16 cents on the dollar. Of course, past results do not guarantee the future.
Since the Tax Cuts and Jobs Act of 2017, muni issuance has shrunk. Thus, the supply of municipal bonds is lower than in previous years. Compared to the average from 2013-2017, this year’s issuance is about 11% lower. On the flip side, demand for municipal bonds has been growing due to their high quality. In basic economics, the law of supply and demand is the backbone of the market economy. In a competitive market, it will determine price. When low supply meets high demand, prices go up. Munis have returned 6.16% in the last six months (ending 4/30/2019). So far this year, muni bonds are up 3.28%, according to Bloomberg Barclay Muni Bond Index, and off to their best start since 2014.
Are municipal bonds for everyone? No, as with any investment, it depends on your individual situation. For high-income investors, who are looking for security and an investment outside of their retirement accounts, municipal bonds may be a fit.
Disclaimer: Nothing contained in this article should be interpreted as a promise or guarantee of earnings or investment results nor a recommendation for the purchase or sale of any security or sector.