Municipal Bonds—An Investment for Hard Times

It seems that most election years there is a proposal from a state or local government to approve a bond to fund a public project such as a new school, open space, or another investment in the public infrastructure. You know you can vote for some of these debt securities, but did you know they are also available for public purchase? They are municipal bonds (also known as “munis”).

Municipal bonds work like other fixed-income products, such as CDs and corporate bonds. Buyers loan the issuer, in this case a municipality, some amount of money to fund a public project. The bond buyer is paid some percentage (the coupon) of the bond’s face amount while the bond remains outstanding. At the end of the holding period, the face amount is returned to the bondholders.

Muni Benefits

Municipal bonds have some unique and attractive features:

• Tax-free income: most munis are exempt from federal tax, and often from state tax.
• Currently, they offer higher yields than taxable U.S. Treasury bonds.
• Historically, municipal bonds have low default rates, as principal and interest are backed by taxes or revenues.
• Considerable variety in issuers, maturity dates and credit ratings.

Taxes

Where do you think tax rates are headed? If up, then the relative return on a municipal bond you hold today will also go up. Consider this: most municipal bonds are exempt from federal income tax, and often they are also exempt from state income tax. So, if your current tax bracket is 35% and you buy a municipal bond with a yield of 4%, your taxable equivalent yield is 6.15% (4 / (1 – 35) = 6.15%). And if the next year your tax bracket goes up to 39%, your tax equivalent yield increases to 6.55% (4 / (1 – 39) = 6.55%). In short, municipal bonds can potentially help offset any hike in tax rates. Of course, the inverse is also true: your taxable equivalent yield will fall if your tax rate decreases.

State Reciprocal Agreements

Many municipal bonds are exempt from state tax for residents of the state where the bonds were issued, but that benefit may extend beyond your state borders. Many states have arrangements with each other wherein they do not tax municipal bonds issued in each others’ states. For example, Utah residents are exempt from paying taxes on municipal bonds issued in Alaska, Washington D.C., Florida, Indiana, Nevada, South Dakota, Texas, Washington, and Wyoming. Investing in bonds that are exempt from state taxes in addition to federal taxes could improve your tax benefit. Check the tax law in the state where you live.

Higher Yields

Municipal bonds can offer safety while currently beating yields on US Treasury bonds (because of the tax exemption, it is rare for municipal yields to be higher than Treasury yields). To demonstrate, the 10 year Treasury currently yields approximately 2.75% while a high grade municipal bond of similar maturity yields around 3.50%.

Lower Defaults

Historically, municipal bond issuers have low default rates. A study done by Moody’s covering 1970 to 2000 shows the 10-year cumulative default rate on rated municipal bonds was only 0.04%. In contrast, the study showed the 10-year default rate for corporate bonds over the same time period was 9.83%†. Investors holding general obligation bonds usually have a higher degree of safety of principal and interest payments because the issuer is required to levy sufficient taxes to pay the obligation.

Variety

With thousands of municipal bond issuers, you get your pick of bonds. You can choose from issuer, bond type (general obligation or revenue), credit rating, coupon, and maturity. The variety gives you the flexibility to meet your investment objectives.

You can also choose how you buy bonds. At Zions Direct, you can participate in our upcoming auctions where we are offering municipal bonds for the first time. Or you can go to Zions Direct’s bond platform—Bonds for Less—and choose from among thousands of bond offerings. If you would like help navigating your options, call the Zions Direct Investment Center to speak to a registered representative at 800-524-8875.

† Moody’s Municipal Default Study, December 2000

*Artwork from Rob Sheridan under Creative Commons license at Flickr.com.

Municipal bonds are not insured by any federal, state, or local governmental agency and may be subject to investment risks, including the possible loss of principal value or amount invested.