Municipal bonds

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Municipal bonds are bonds issued by states and local governments.

Types of municipal bonds

  • General Obligation Bonds are municipal bonds secured by the taxing and borrowing power of the municipality issuing it.[1]
  • Revenue Bonds are municipal bonds supported by the revenue from a specific project, such as a toll bridge, highway, or local stadium.[2]
  • Assessment Bonds are special types of municipal bonds used to fund a development project. Interest owed to lenders is paid by taxes levied on the community benefiting from the particular bond-funded project.[3]
  • Build America Bonds are municipal bonds issued under a program begun in 2008. Through the BAB program, the Federal government directly subsidizes taxable municipal bonds instead of subsidizing municipal bonds via a tax break for their purchasers. This opens the market up to a wider range of participants, including tax-exempt institutions and individuals with sufficient tax-exempt space.

Taxation

Interest

Interest from municipal bonds is generally exempt from federal income tax and the issuing state's income tax.[note 1] However, there are a few exceptions.

  • Interest from some municipal bonds is subject to Alternative Minimum Tax (AMT) although whether you actually have to pay AMT depends on your individual circumstances. Such bonds are commonly referred to as AMT bonds.
  • Some states charge income tax on interest from their own municipal bonds.

Areas of note:

  • Puerto Rico, Guam, and US Virgin Islands: No state can tax bond interest issued by US territories.[4]
  • New York City: Bonds issued in NY may be triple tax-exempt from city, state, and federal income taxes.[4]
  • Utah: Utah reciprocates taxation. Utah does not tax its own bonds, but also does not tax bonds issued in states that do not tax Utah bonds.[4]
  • Washington D.C.: Does not tax in-state or out-of-state municipal bonds.[4]

Capital gains/losses

Capital gains and losses are subject to taxation. One notable point is the treatment of capital losses for a holding period of less than six months. For an ETF holding bonds (but not for a traditional mutual fund if the fund accrues dividends daily and pays them at least monthly, as most bond funds do), if you received exempt-interest dividends, at least part of your loss is disallowed. You can deduct only the amount of loss that is more than the exempt-interest dividends. Report the loss as a short-term capital loss. See Publication 550 (2012), Investment Income and Expenses and Short-Term Capital Losses for more details.

Risks

Call risk

Many bonds are issued with provisions which allow the issuer to repay the bond before the bond reaches maturity. This is termed "calling" the bond. Since issuers call bonds when interest rates fall and the the cost of financing the debt is cheaper in the new lower rate environment, a called bond is disadvantageous to the investor, who now must reinvest the returned capital at lower interest rates. An additional risk with a bond with a call feature is the tendency of the bond to have shifting durations as the likelihood of a call rises and falls with the fluctuation of market interest rates. The bond will sometimes be priced to the call date (when interest rates are falling); at other times to the maturity date (when interest rates are rising).[5] Bonds with a call feature usually pay a higher interest rate than non-callable bonds as partial compensation for the increased risk.

Credit risk

Credit risk is generally much less than that for corporate bonds. Nonetheless, it exists.(Refer to Moody’s US Municipal Bond Rating Scale for data on defaults). While only 5 corporations have a AAA credit rating, 16 states are rated AAA. Furthermore over 90% of municipal bonds are rated A or better by Fitch, while the average corporate bond is rated in the B range[6]. The default rates reflect those higher ratings. According to a report by Moody’s[7] which covers the default rates of municipal bonds from 1970 to 2011, the average default rate of rated municipal bonds was .13% during that time. That compares to an average default rate of 11.17% for rated corporate bonds over that same time period.

Some municipal bonds are insured by private insurance companies. (AFGI - The Basics}

Some investors seek to mitigate the credit risk by diversifying their municipal bonds beyond the state of residence. The caveat is that they may have to pay state income tax on the interest from out-of-state municipal bonds.

Liquidity risk

Municipal bonds are generally illiquid,[8] especially at the retail level. To mitigate the risk, you may consider holding them to maturity or holding them through a low-cost mutual fund, which can trade on the wholesale market.

Meredith Whitney

In 2010 analyst Meredith Whitney was interviewed on 60 Minutes and predicted that there would be 50 to 100 sizable defaults[9]. Whitney came to fame by being one of the first analysts to predict the banking crisis in 2008, so many investors took that statement to heart. According to a Vanguard article on the topic[10], from November of 2010 to November of 2011 investors withdrew $35 Billion from municipal bond funds. Unfortunately for those investors her prediction did not come true this time and the municipal bond market rallied over 12% during that time.

Role in a portfolio

  • If you have filled up your tax-advantaged accounts with tax-inefficient assets (taxable bonds, REITs, commodities, etc), and you still need bonds to meet your desired stock/bond asset allocation, you might consider placing municipal bonds (or a mutual fund thereof) in your taxable account.
  • If you are in high tax brackets, and you are saving for short-term cash needs (such as car, home down payment, etc), then you might consider short-term municipal bonds or tax-exempt money market funds. (Note that Vanguard's tax-exempt money market funds contain AMT bonds. Fidelity offers some AMT-free tax-exempt money market funds as well as those with AMT bonds in them.)

Taxable equivalent yield

Taxable equivalent yield of a municipal bond is one that a taxable bond would have to pay to deliver the same amount of income as the municipal bond. The taxable equivalent yield depends on the investor's tax brackets. The following calculators allow you to calculate the taxable equivalent yield.

It's important to calculate the taxable equivalent yield before purchasing municipal bonds because taxable bonds with comparable credit ratings may have greater yields.

Notes

  1. States with no income tax do not impose taxes on municipal bonds.

See also

References

External links

Further reading

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