Municipal Bonds, Part 2

Municipal bonds fund all kinds of construction projects. Many roads, schools, soccer stadiums, airports, and convention centers have been built with the money raised when a municipal government issues municipal bonds. A municipal government includes everything from a state government down to the local school, library, or museum board. When these municipal entities need to raise money, they issue bonds to investors. Usually, the investors are in high tax-brackets and are looking for some interest that is tax-free at the federal level, and also tax-free at the state level if the bonds are issued inside the investor’s state of residence. Now, if a high-tax-bracket resident of, say, Maryland, buys a municipal bond issued within the state of Maryland, the interest he receives is exempt from taxation at both the federal and state level. Not surprisingly, the rate of interest the bonds pay is lower than what corporate bonds pay. But, since this interest is tax-free, the municipal bond often offers a higher yield than a comparable corporate bond after we figure in the taxation. For example, let’s say you were looking at two 10-year bonds rated AA by S&P, one a taxable corporate bond, the other a tax-exempt municipal bond. The municipal bond has a 7% yield, while the corporate bond yields 10%. Which one should you buy? Actually, we don’t know yet. Not until we factor in your tax bracket. Believe it or not, if you were in the 30% federal tax bracket, these two bonds would be exactly equal. The municipal bond would pay you $70 per bond tax-free. The corporate bond would pay you $100, but then the federal government would take back $30 of it, leaving you at exactly the same place. If you were in the 35% bracket, the municipal bond would edge out the corporate bond. An equivalent corporate bond would have to yield 10.77% to match the municipal bond for an investor in the 35% bracket. Since it doesn’t (it only offers 10%), the investor in the 35% bracket would purchase the 7% municipal bond and come out ahead versus buying the 10% corporate bond.
Does that imply that lower-bracket investors typically don’t come out ahead buying municipal bonds? It does. And, if you’re investing in a tax-deferred account (401k, 403b, IRA, etc.) you do not buy municipal securities as a general rule. If you did that, you would end up turning what was supposed to be tax-exempt interest into withdrawals taxed at ordinary income rates. In other words, using our example above, you’d be getting 7% instead of 10% and then also paying tax on that money when you start taking withdrawals from the account. Which makes no sense. We’ll talk in more detail about how tax-deferred accounts work later. For now, remember that we’re still just introducing you to the basics involved with investing.