Municipal Bonds Pay Less and Can Still Leave You With More
Interest from most municipal bonds is exempt from federal income tax. That changes the arithmetic enough that a lower headline yield can beat a higher one.
The Exemption
A municipal bond is debt issued by a state, city, county, or an authority such as a school district or transit agency. Interest on most of them is exempt from federal income tax, and often from state tax as well if you live in the issuing state.
The exemption is old, rooted in the principle that one level of government should not tax the borrowing of another. Whatever its origins, the practical effect is that municipal issuers borrow more cheaply than their credit quality alone would justify, because buyers accept a lower rate for tax free income.
Making the Comparison Work
A muni yielding 3.2 percent and a corporate bond yielding 4.5 percent are not directly comparable, because one of those numbers is after tax and the other is not.
The tax equivalent yield converts the muni to a pre tax basis. Divide the muni yield by one minus your marginal tax rate.
| Marginal rate | 3.2 percent muni becomes | Versus 4.5 percent corporate |
|---|---|---|
| 12 percent | 3.64 percent | Corporate wins |
| 24 percent | 4.21 percent | Corporate wins |
| 32 percent | 4.71 percent | Muni wins |
| 37 percent | 5.08 percent | Muni wins clearly |
The same bond is a good investment for one person and a poor one for another, with no disagreement about the bond. The variable is the buyer's tax bracket, not the credit.
Who They Are Built For
This is why municipal bonds are concentrated among high income investors. Below roughly the 24 percent bracket the exemption rarely compensates for the lower yield, and taxable bonds are simply better.
It is also why holding munis inside a tax advantaged retirement account is a mistake. That account already shelters the income, so you have accepted a lower yield for a benefit you were already receiving.
The Credit Side
Municipal defaults are rare but not absent, and the category is not uniform.
General obligation bonds are backed by the issuer's taxing power. Revenue bonds are backed only by the income of a specific project, such as a toll road or a hospital. A revenue bond is a project financing wearing a municipal label, and the analysis required is closer to corporate credit.
Detroit's 2013 bankruptcy and Puerto Rico's restructuring both demonstrated that a government issuer can impose losses on bondholders. The general safety record of the sector is real, and it does not extend automatically to every issuer within it.
The Complications
Several traps sit around the edges of the exemption.
Capital gains on munis are taxable even though the interest is not, so buying at a discount and holding to par creates a taxable gain. Some municipal interest counts toward the alternative minimum tax calculation for certain investors. Municipal interest can also affect the taxability of Social Security benefits, an effect that surprises retirees.
Liquidity is the other constraint. There are tens of thousands of individual municipal issuers and most bonds trade rarely, so bid ask spreads for small retail lots can be wide enough to erase a meaningful part of the tax advantage.
The Bottom Line
Municipal bonds pay less on the surface and can deliver more after tax, but only for investors in higher brackets. Run the tax equivalent yield before comparing anything. Then check whether the bond is a general obligation or a revenue bond, because the exemption tells you about the tax treatment and nothing at all about whether you get repaid.