What it means
When a local authority needs to build a school, resurface roads or extend a water system, it can either raise taxes or borrow, and borrowing spreads the cost across the decades that will benefit from the asset. Investors who lend get regular interest, usually paid twice a year, and their principal back at maturity.
The tax exemption is the whole point of the market and is why comparing a muni yield with a corporate bond yield directly is meaningless. The right comparison uses the tax equivalent yield, which grosses the tax free rate up to the pre tax rate a taxable bond would need to match it.
Because the benefit scales with the investor's tax rate, munis suit high earners and are usually a poor choice inside a pension or other tax sheltered account. Putting a tax free bond into an account that was already tax free simply gives away yield for nothing.
Two main structures exist. General obligation bonds are backed by the issuer's taxing power, while revenue bonds are repaid only from the income of a specific facility such as a toll road, airport or hospital, which makes them riskier and better paying.
Default is historically uncommon in this market but it is not unknown, and liquidity can be thin because many issues are small and held to maturity. Most private investors get exposure through a fund rather than by buying individual bonds, which spreads issuer risk and makes selling easier.
In practice
Real-world examples.
Example
A surgeon in a high tax bracket moves $250,000 from a corporate bond fund into a muni fund yielding 3.4%. Her after tax income rises even though the headline yield falls, because the corporate fund's 4.8% was taxed at her marginal rate.
Example
A city issues $40 million of revenue bonds to expand its convention centre, repayable only from hotel taxes and venue fees. Investors accept a higher yield than on a general obligation issue because the repayment depends on the venue actually being used.
Example
A financial adviser stops a client from holding munis inside a tax deferred retirement account. The client had been earning 3.1% tax free where a taxable bond at 4.7% would have compounded faster inside that wrapper.
Think of it
“Muni bond is the abbreviation for municipal bond-local government tax-free debt.
Formula
Calculation
Tax equivalent yield = tax free yield / (1 - marginal tax rate)
An investor in the 35% federal bracket is offered a municipal bond yielding 3.2% and a corporate bond yielding 4.6%. The muni's tax equivalent yield = 3.2% / (1 - 0.35) = 3.2% / 0.65 = 4.92%.
On that basis the muni wins, because the corporate bond would need to yield more than 4.92% to leave the investor with the same money after tax. Check it in dollars on a $100,000 holding: the muni pays $3,200 and the investor keeps all of it, while the corporate bond pays $4,600, of which 35% or $1,610 goes in tax, leaving $2,990. The muni is $210 a year better off despite the lower headline rate.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Ridgeway Dental Group, an invented practice whose two owners drew high incomes, held $600,000 of surplus cash in a taxable corporate bond fund yielding 4.9%. Their accountant pointed out that after federal and state tax the partners were keeping barely 3% of it.
In this fictional scenario the practice moved the personal portion of those savings into a mix of in state municipal bonds yielding 3.3%, of which the owners kept every cent. Their after tax income improved by roughly $2,000 a year on the same capital, with no increase in credit risk.
The accountant added one caution that the owners took seriously: because the exemption is worth nothing to a low rate taxpayer, the plan would need revisiting if either partner cut back their hours and dropped into a lower bracket.
Watch out
Common mistakes.
- Comparing a muni yield directly with a taxable bond yield instead of converting it to a tax equivalent basis first.
- Holding municipal bonds inside a tax sheltered account, which wastes the exemption that is the main reason to own them.
- Assuming all munis are equally safe, when a revenue bond tied to a single facility carries far more risk than a general obligation issue.
Questions
People also ask.
Are municipal bonds always completely tax free?
No, some issues are subject to alternative minimum tax and capital gains on a sale before maturity are taxable, so only the coupon interest is generally exempt.
Who should not bother with munis?
Investors in low tax brackets, and anyone investing through a pension or similar account, since they give up yield for a benefit they cannot use.
Is a fund better than buying individual bonds?
For most private investors yes, because a fund spreads issuer risk across hundreds of bonds and is far easier to sell in a hurry.
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