Municipal Bond Advantage

The video that accompanies this blog is here:

Given the renewed interest in bonds, we are proceeding with our series of bond videos and planning an in-person meeting in January. We aim to enhance our clients’ comprehension of this topic, so we also have created this video for your review.

Municipal bonds, often called “munis,” represent debt securities issued by governmental entities, such as states, cities, and counties. These bonds fund various expenses, including day-to-day obligations and significant projects like school construction, road development, or sewage systems. When you choose to invest in municipal bonds, you are essentially extending a loan to the issuing government entity. In return, you receive regular interest payments, typically semi-annually, along with the eventual repayment of your initial investment, known as the “principal.” The maturity date of a municipal bond, which indicates when the issuer will repay the principal, can vary, with short-term munis maturing within one to three years and long-term ones having maturity dates that may span more than a decade.

Advantages

Higher Credit Quality

Historically, municipal bonds, or munis, have consistently demonstrated a notably higher credit quality when comparing them to corporate bonds, particularly when examining various indexes.

Most investment-grade municipal bonds fall within the A-AAA credit rating range, signifying their strong financial standing. Defaults on municipal bonds are relatively rare, especially for those issued by financially stable municipalities. According to Moody’s data, the average municipal default rate since 1970 has been a mere 0.08%. In stark contrast, the average global corporate default rate during the same period has been significantly higher, at 6.9%. This stark contrast in default rates makes municipal bonds an appealing choice for income-focused investors, including retirees.

Availability for Individual Investors

The municipal bond market boasts a striking difference from the corporate bond market, with approximately 20 times as many individual municipal bonds available. Nearly one million municipal bonds are outstanding, while corporate bonds are in the thousands. This vast municipal bond market involves 44,000 issuers in the United States, making it one of the largest sub-sovereign markets worldwide.

Interestingly, many of these municipal bonds have maturity sizes under $5 million, and roughly one-third are under $1 million. This unique characteristic makes the municipal bond market accessible and appealing to individual investors.

Tax Savings

You can generate income from municipal bonds by collecting regular interest payments like corporate bonds. However, municipal bonds have a crucial advantage: the interest payments are not subject to federal taxes. If you invest in bonds from your home state, you’ll also avoid state and local taxes. If you hold municipal bonds from your home state, earning $1,000 in interest yearly means you get to keep the entire $1,000.

In contrast, with corporate bonds, your interest income is typically taxed at ordinary income tax rates, which could be as high as 37%. So, if you receive $1,000 in income from a corporate bond, your after-tax income would be only $630 after taxes.

To compare the real return on municipal bonds with corporate bonds, use the tax-equivalent yield formula: Tax Equivalent Yield = Tax-Free Yield / (1 – Tax Rate). This formula calculates the yield a municipal bond must have, in addition to its federal tax-free status, to be equivalent to a corporate bond’s yield.

Types of Municipal Bonds

State and local governments typically issue general obligation (GO) bonds in the United States. These bonds are backed by the full faith and credit of the issuer, which means that the issuer commits to using all available resources, including tax revenue, to repay the bondholders. These are considered the safest bonds.

Revenue bonds are a type of municipal bond that is issued to finance specific revenue-generating projects or facilities. Unlike general obligation bonds, backed by the issuer’s full faith and credit, revenue bonds are backed by the revenue generated by the financed project or asset.

Unlike general obligation bonds, revenue bonds do not rely on the issuer’s taxing power or general funds for repayment. This means that if the revenue generated by the project falls short, bondholders may not have the same level of protection as with GO bonds.

Revenue bonds can finance various projects, from large-scale infrastructure like airports to smaller-scale projects like municipal parking garages or housing developments. The risk associated with revenue bonds can vary depending on the specific project and the economic conditions that affect its revenue streams. Investors should carefully assess the financial health of the project and the issuer before investing in revenue bonds.

In Closing

Most of our clients have a basic understanding of bonds and their role in their portfolios. They recognize that bonds provide diversification and are generally less risky than stocks. Some people dismiss them or think they are boring. We find bonds to be an exciting and necessary asset class that belongs in most portfolios. Please RSVP if you would like to attend one of our in-person meetings to learn more about bonds. 

  • Date: Thursday, January 4, 2024,
  • Time: 5:30 pm – 8:30 pm
  • Where: Laurel Oaks Country Club, 2700 Gary Player Blvd, Sarasota

Or

  • Date: Thursday, January 24, 2024,
  • Time:  6:00 pm – 8:00 pm
  • Where: William Patterson University Library Auditorium 300 Pompton Road Wayne, NJ 07470

We hope to see you there.

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