The fundamentals of municipal bonds and taxes

After my colleague’s recent post on tax liability, investors have been peppering us, and financial advisors we know, with lots of questions about municipal bonds (aka “munis”) ? in particular, how they affect taxes.

How do munis work? How might they fit into investors’ portfolios? What’s the best way to buy them? What are the tax advantages?

Consider the unique aspects of this asset class:  There’s no central exchange and, of the 87,000 issuers, less than 1% trade daily¹ in the market. In terms of orderly trading, the muni market is somewhere between rough-and-tumble and outright unruly. Bond issuers, also called municipalities, are public entities such as state and local governments that sell bonds publicly to raise money for infrastructure projects such as schools, hospitals, roadways and water systems.

One of the attractions for investors, of course, is that interest income (otherwise known as the coupon) from munis is generally tax-exempt at the federal level in the United States. For many investors this means they may be able to afford to get paid a lower interest rate than, say, the rates on corporate bonds, and still come out ahead in after-tax returns. Though capital gains taxes remain a concern; we’ll discuss that in a bit.

It is also important to note the certain aspects of state taxes in relation to municipal bonds for U.S. investors. If an investor purchases a bond from one’s home state, generally it will also be exempt from state income taxes. However, interest paid on bonds from outside of an investor’s home state is generally subject to state income tax. This kind of state tax can potentially reduce the net income one might receive from the bond.

Purchasing municipal bonds

In my experience, two approaches deserve consideration when buying municipal bonds: ladders and funds.

A bond ladder is a portfolio of fixed-income securities with different maturity dates. Advantages to this approach include lower risk of recognizing capital gains taxes due to the lower turnover of the strategy (see: How tax efficient is your municipal bond portfolio?) and direct ownership of the underlying bond holdings. Also, fees that investors pay are generally lower than those of bond funds, though at the cost of being managed passively instead of actively.

Yet, as with any investment, there are risks to this approach. Because bond ladders are often managed passively or only reactively, bonds tend to be sold after a negative credit event rather than before. Bond ladders are also concentrated in fewer securities because only a select number of investors have the scale (net worth) to be fully diversified, therefore making them more vulnerable to losses. To dampen the concentration risk, some investors may choose to focus on buying AAA-rated securities (the highest grade available, which comes at a lower return rate due to lower credit risk) and this added measure to help address risk may lower their potential returns.

The other approach to consider for investing in municipal bonds are muni bond funds, which tend to be more diversified, provide more liquidity, are typically actively invested across the ratings spectrum and, because of their scale, have the ability to purchase bonds at lower trading costs. For example, an individual investor pays about 1.6% in costs for a trade between $25,000 and $100,000, while a fund manager pays just 0.3% on a trade over $1 million² .

Don’t forget capital gains

Despite the tax advantages of municipal bonds, investors need to stop short of thinking of munis as entirely tax-free. While interest income from municipal bonds is typically tax-free at the federal level, any price gain resulting from buying and selling the bonds can create capital gains. Only 29% of the funds in the Morningstar® Municipal National Intermediate universe have not had a taxable distribution in the 10 years ending 2014. My colleague, Frank Pape, will be post some insights on capital gains here soon.

For more on the pros and cons of munis, check out my recent blog post on our companion blog site, Helping Advisors.

¹Today’s Municipal Bond Landscape Requires Active Management. New York Life MainStay Investments, 2014.

²Municipal Securities Rulemaking Board (MSRB), S&P and AllianceBernstein. As of December 31, 2013.