Are muni bonds for me?
Q: I watched President Biden’s speech Wednesday night and it sounds to me like tax rates are definitely going higher. It also sounds like I might lose more of my tax deductions. Should I start investing in municipal bonds?
A: Municipal bonds can be a great source of tax-free income when they are used correctly. However, whether or not muni bonds make sense for you depends on several things, including your overall investment objectives and your personal marginal tax rate.
Before you buy muni bonds, consider carefully if bonds generally should be part of your portfolio. Bonds might fit for several reasons. First, bonds can reduce portfolio volatility. Bond price volatility is typically much less than the volatility of stock prices. In addition, bond prices usually exhibit low correlation with the movement of stock prices.
Second, bonds are sometimes used to bring income into a portfolio. Unfortunately, income is a rare commodity in today’s low-yield environment. To illustrate my point, high quality companies typically pay a dividend equal to somewhere around 1.8 percent of the stock’s market price. After adjusting for taxes, the return you would actually earn would be somewhere around the 1.35 percent. In contrast, an intermediate maturity corporate bond will yield about 1.0 pretax and 0.65 after-tax. A municipal bond issued by a single-A credit would probably produce a yield of 0.55 percent.
Finally, bond’s give you a more senior claim on the assets of the issuing company than you get if you own the company’s stock. Under normal circumstances this is no big deal. However, in periods of economic stress, the added protection can make a huge difference in the performance of your investment.
Once you decide that bonds are a good fit, the decision of which type of bond to buy depends on the type of account you have and which type of bonds produce the best after-tax returns. Under normal circumstances you would never put a tax-free muni bond in an IRA. However, if you are working with a taxable portfolio, tax-free muni bonds might make sense if their yield compares well with taxable bond yields. To make the comparison, we need to calculate the municipal bond’s taxable-equivalent yield.
Taxable-equivalent yield grosses up the muni bond’s tax-free yield to what it would be if it were taxable, enabling you to directly compare the muni bond yield with yields on taxable bonds. To calculate the taxable equivalent yield, divide the muni bond’s yield-to-maturity by one minus your marginal tax rate. For example, at the time of this writing, AA-rated California muni bonds with five years to maturity yield around 0.50%. If my combined state and federal marginal tax rate were 43%, the muni bond’s taxable equivalent yield would be 0.88%. A corporate bond of similar quality and maturity yields 1.15%, so the muni bond is currently a less attractive investment.
The tax professional who prepares your taxes can help you get a good estimate of your marginal tax rate. If you prepare your own taxes, you can estimate your marginal tax rate using the IRS tax tables at www.IRS.gov.
One final word of caution: the bond market can be difficult to navigate. Because bonds are traded over-the-counter, prices are not transparent. At the same time, bond structures can be very complex. If you are going to invest in bonds, it pays to work with an advisor who has significant experience in this part of the market. For most people, a better approach would be to stick with a well-managed bond mutual fund.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to: firstname.lastname@example.org