Less Taxing Investments with Municipal Bonds

With speculation growing that tax rates may be heading higher to compensate for increased government spending, investors are looking for ways to cut taxes. Municipal bonds—debt securities issued by cities, counties, school districts, state governments and other public entities—have become increasingly attractive in recent months, not just due to the tax climate, but also because of their relative value. These bonds began to be priced at levels that made them quite attractive compared to other fixed-income options like Treasury bonds or certificates of deposit.

The primary attraction of municipal bonds is a tax benefit because income taxes are generally not levied on interest generated by the securities though capital gain taxes that may apply on their sale. That is why you often hear them referred to as tax-exempt bonds. For individuals and couples in higher tax brackets, comparisons to other types of fixed income investments on an after-tax basis can look quite attractive. In the current market environment, the after-tax advantage with municipal bonds has the potential to be significant, depending on the type of security.

Not all municipal bonds are alike

When discussing tax-exempt securities, it is important to point out that there are different bond categories that make up this segment of the market. Among the options are:

• General Obligation Bonds—the principal as well as the income generated by General Obligation (G.O.) bonds are backed by the ability of the bond issuer (a school district, for example) to levy taxes in order to pay bondholders. That taxing authority makes these types of bonds a fairly reliable option in most situations.

• Revenue Bonds—these bonds are backed by revenue generated by the specific public project or enterprise. A city’s water system, which charges fees to users, would be an example of a project underwritten by revenue bonds.

• Pre-refunded Bonds—these are bonds that aren’t just backed by the issuing entity, but also by U.S. Treasury securities. They tend to have the least amount of risk associated with them in relation to other types of municipal bonds.

Why choose municipal bonds?

Income generated by municipal bonds is not generally taxable at the federal level. If purchasing a bond from an issuer in your own state, the income will also generally be free of state tax requirements. Income from certain private activity bonds may be subject to the federal alternative minimum tax (AMT) although bonds issued in 2009 and 2010 may be exempt from this AMT.

Because of this, the interest rate on municipal bonds is typically lower than yields on taxable bonds of a comparable nature. To make the comparison, you want to determine the tax-equivalent yield of a municipal bond or bond fund that you may be purchasing.

For example, if you are in the 28 percent federal tax bracket, a taxable bond paying 5.2 percent would yield, on an after-tax basis, 3.75 percent. A comparable tax-exempt bond that pays a yield of more than 3.75 percent would generate a more favorable return for the investor than the taxable bond. Of course, when comparing options, after-tax yield should be only one consideration in judging the appropriateness of a bond (or bond fund).

The higher the individual’s tax bracket, the more valuable the tax-exempt feature of municipal bonds. One that generates a 3.75 percent yield would be paying the equivalent, when taxes are taken into account, to a taxable bond at these different tax rates:

Yields on U.S. Treasury securities have been at historically low levels, meaning that certain comparable municipal bonds and municipal bond funds may offer a significant, after-tax yield advantage and many are choosing that option.

AJ Jugan and Brian Stumpf are financial advisors and Certified Financial Planner™ professionals. Andrew (AJ) can be reached by calling 412-635-5813 or emailing andrew.m.jugan@ampf.com. Brian can be reached by calling 724-799-2782 or emailing brian.d.stumpf@ampf.com.