Municipal bonds

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This is a bond issued by a state, city, or local government. Municipalities issue bonds to raise capital for their day-to-day activities and for specific projects that they might be undertaking (such as developing local infrastructure like roads, sewers, parks, hospitals, etc). Interest on municipal bonds is generally exempt from federal taxes, and bonds bought by a resident of the state or other localities are typically exempt from taxes on the interest by the issuing body. Yields on municipal bonds are often lower than corporate or Treasury bonds with comparable maturities, because they have important tax-free advantages. Municipal bonds are considered safer, low-risk investments than corporate bonds, since a municipal government is much less likely to go bankrupt than a corporation. Some municipal bonds are insured by outside agencies, usually a monoline insurer, which promises to pay the interest and principal if the bond's issuer defaults.

Investing in Muni Bonds

Municipal bonds—often referred to as "munis"—are bonds that are issued by municipalities to raise money for projects ranging from road construction projects and new power plants to building parks and zoos.

Munis work no differently than any other bond. Munis have a face value, a coupon rate and a maturity date. However, munis do have one distinct advantage over other bonds—they provide tax-free earnings.

The Federal Government does not count earnings from munis as part of taxable income. This tax treatment helps incentivize individuals to invest in municipal bonds.

Types of Municipal Bonds

There are two primary types of municipal bonds which are referred to as general obligation and revenue bonds. With general obligation bonds, the government entity that issues the bonds puts their "full faith and credit" behind the bonds. Revenue bonds are backed not by the pledge of the government entity but by the revenues of the project for which they were issued to fund. Examples of the types of projects funded with revenue bonds are water and sewage plants, toll roads, and hospitals. If the revenue from the specific project is not sufficient to cover the payments owed to bondholders, then the government entity that issued the bonds is not required to step in and make payments. For this reason revenue bonds are generally considered safer than revenue bonds.

Taxable equivalent yield

Most municipal bonds are free from federal taxes, and if the issuer of the bond is located in the same state where you reside, they can be free of state and local taxes as well. This means that the attractiveness of a municipal bond vs. a corporate or treasury bond is going to vary based on the rate of tax that you pay.

For example, lets say that a tax free municipal bond yields 5% and my federal and state tax rates are 25% and 7% respectively. In this instance I would need a 7.17% on a taxable bond in order to get 5% after taxes. As you can see from this example, the higher that rate of tax you pay, the more attractive municipal bonds are going to be.

Municipal Bond Safety

The default rate for municipal bonds is much much lower than it is for corporate bonds. A report by Moody's[1] which covers municipal bond default rates from 1970 to 2011 shows that the average municipal bond default rate was .13% during that time. This compares to an average default rate for corporate bonds of 11.17% over that same time period.

This shows up in the average credit ratings for municipal bonds compared to corporate bonds as well. The average credit rating for all rated municipal bonds is A. That compares to an average credit rating of B for corporate bonds.

Muni Bond Funds

In a municipal bond fund like the Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares (VWITX), providing exposure to not one but hundreds of municipal bonds. This gives diversification at a relatively low cost.

References

  1. http://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_140114
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