Q: I switched advisors recently and he suggests I sell my muni bonds and buy corporate bonds instead. His advice confuses me because I feel like I already pay a lot of taxes and I don’t want to do anything that would add to my taxable income. I don’t do a lot of charitable giving, so my tax deductions are limited. Would I really be better off in corporate bonds?
A: Municipal bonds can be a great source of tax-free income when they are used correctly. 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 help reduce portfolio volatility. Despite their terrible performance in 2022, bond prices usually fluctuate much less than stock prices. In addition, bond prices usually exhibit low correlation with the movement of stock prices.
Another reason you might want to own bonds is to increase your portfolio income. In today’s market, dividend-paying stocks from high quality companies typically pay dividends around 1.6% of their market price. In contrast, an intermediate maturity bond issued by a similar company would probably yield 4.3%.
Finally, bond investors have a more senior claim on the assets of the issuing company. This is significant during times of economic stress because bond holders are more likely to recover more of their investment than stockholders in the event the company slips into bankruptcy.
After considering all these factors, the decision of whether to buy corporate bonds or municipal bonds depends on which one will produce the best after-tax returns. The pre-tax yield on a taxable corporate bond will always be greater than the yield on a tax-free municipal bond with the same credit rating. A tax-free municipal bond would be a sensible investment if your tax rate is high enough to offset the corporate bond’s yield advantage. To make the comparison, we need to calculate something called 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 ten years to maturity yield around 3.2%. If my combined state and federal marginal tax rate were 43%, the muni bond’s taxable equivalent yield would be 5.6%. It is calculated like this: 3.2% / (1- .43) = 5.6%. A corporate bond of similar quality and maturity yields only 4.96%, so in this case the municipal bond is a more attractive investment.
However, if you were in a lower tax bracket, the municipal bond might look less attractive. For example, if my combined state and federal marginal rate were only 20%, the muni’s taxable equivalent yield calculated as 3.2% / (1-.20) or 4.0%. With a low marginal tax rate, you are better off buying the corporate bond and paying taxes on the income.
The CPA or enrolled agent 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 municipal bond market can be treacherous. Because muni bonds are traded over-the-counter, prices are not transparent and bond structures can be very complex. If you are going to invest in muni 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 municipal 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