In a challenging market year, many investors are looking to shift to a more risk-off investment approach while seeking reliable sources of income. One asset class that could be worth consideration — particularly for their tax benefits — is municipal bonds, commonly referred to as “munis.” Munis offer key tax benefits, though these can vary by state and region.
What Are Municipal Bonds?
Municipal bonds are bonds issued by local, state, and federal governments specifically to finance projects, such as new roads and bridges, new schools or fire stations, or the upgrade of sewer systems and municipal transportation fleets.
Because they are designed to help support local infrastructure, the majority of muni bonds aren’t subject to federal tax. Depending on the geographic location of the muni in relation to the investor, they can also be tax-free for state taxes, as well.
Why Invest In Munis?
Munis generally offer smaller interest payments than some of their other bond counterparts, such as corporate bonds, but if invested strategically, they can offer entirely tax-free income opportunities for a portfolio that make them appealing and worth navigating the tax complexities.
Because of their ability to provide tax-exempt income, they are best used in taxable accounts for retirement portfolios. However, investors who are drawing Social Security should be aware that interest on munis counts on the taxable income portion come tax season.
Municipal bonds are also appealing in a market environment of volatility and uncertainty, because they have much lower default rates. They held up surprisingly well during the worst impacts of the pandemic when much of the economy was shut down in 2020 according to Moody’s Investors Service’s 51-year study of municipal bond defaults through 2020.
“The average five-year municipal default rate since 2011 was 0.12%, higher than the 0.08% rate for the entire study period, but lower than the average five-year corporate default rate of 7.4% since 2011,” explained Varun Agarwal, a vice president at Moody’s and senior credit officer as well as the co-author of the 2021 study. “Municipal ratings were relatively stable in 2020, compared to both corporates and the prior year.”
How To Harness The Tax Benefits Of Munis
The state tax benefits that munis can provide are particularly useful for investors that live in high-income tax states, such as California, which has an income tax rate above 13% for the highest income bracket. High-income investors would benefit the most from the tax break, so it makes sense for an investor that lives in California to invest in municipal bonds within their state for the tax break, whereas investing out-of-state would result in being taxed.
For investors that live in tax-free states such as Texas, Florida, and others, the options are limitless in investing in munis from out-of-state since no tax will be applied.
The same goes for states like Wisconsin, Illinois, Oklahoma, and Iowa that do not offer a tax break for investing in local munis. Looking further afield could present better opportunities.
How To Use Munis For Diversification
Another reason that investors might consider munis nationally are the diversification benefits. Municipal bonds come in two main types:
- General obligation bonds, which are backed by the issuer (the local government) and are paid via local taxes on residents. This type of bond is considered one of the most secure types of munis with the least risk and as such generally pays the least in interest rates.
- Revenue bonds, which aren’t backed directly by the tax mechanisms of the local government but instead rely on revenues made from the project they target. This can be anything from tolls made on highways to lease fees from municipal government projects, the projects that are improving and building out local infrastructure. Because they are based on the revenues from projects, they are dependent on how successful the project is and carry more risk while offering more attractive interest rates as compensation.
Investing in both municipal bond types as well as locations can help to mitigate risks that might be intrinsic to one area. Muni ETFs are another great way to capture diversification beyond just individual investment, often using a balanced approach to municipal bond investments to mitigate risk.
Advisors and investors should be aware that muni ETFs are susceptible to interest rate changes as well as realizing capital losses as the fund moves out of positions in muni bonds compared to the buy-and-hold strategy that can be employed with single municipal bond investment.
For investors looking for detailed disclosures from municipal bond issuers, the Municipal Securities Rulemaking Board maintains a database, and the SEC offers a good jumping-off point for a wide variety of information on both muni markets and individual munis.
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