Introduction to Municipal Bonds

| July 31, 2012 | 0 Comments

During the past quarter, three municipalities in California filed for bankruptcy protection. The City of Stockton, followed shortly by Mammoth Lakes, and most recently the city of San Bernardino. Each municipality has been rocked by a combination of economic stagnation, declining revenues (property and sales taxes) and, in the case of San Bernardino, (possibly criminal) mismanagement. So I thought I’d write about municipal bonds (or “muni bonds”) this month.

I know of very few investors who don’t like the idea of tax-free income. But when does it make sense? And how are muni bonds different from, say Treasury bonds or corporate bonds? Let’s start with some basics.

Muni bonds are debt issued by states, counties, cities and other entities like school and water districts to fund large public projects like roads, schools and reservoirs. Buyers of muni bonds are, in essence, lending money to these government entities. In order to encourage private funding of state and local projects, the U.S. tax code provides that income from most muni bonds is Federal income tax-free. States generally will not tax muni bonds issued in that state, but do tax bonds issued by out-of-state entities. Thus, San Diego city muni bonds might be state tax-free to a California resident, but not for someone living in Oregon.

Some muni bonds, which are not used to provide sufficiently public benefits, are not tax free. Examples include bonds issued to fund mostly private projects like stadiums, or to fund pension benefits for municipal employees.

Muni bonds may be backed by different funding sources. Those backed by the taxing authority of a government entity are called general obligation bonds. These bonds are the “safest” of muni bonds, since the interest and principal are generally payable before all other liabilities of the issuing entity. State muni bonds are generally considered safer than local government bonds, especially in California where the state has significant control over local property tax revenues.

Revenue bonds, on the other hand, are generally funded by the revenues generated by a specific project. This could include tolls from a highway or bridge, water or sewer fees, airport revenues, etc. To understand how different these bonds can be, imagine a bond that is backed by the water system revenues of a city like Los Angeles versus a bond backed by property tax revenues in San Bernardino.

There is clearly a very wide variety of muni bonds, and understanding the credit quality of the issuer is just as important as understanding the terms under which each individual bond is issued. According to one industry paper, the muni bond market is approximately $3 trillion dollars and comprised of over 1.5 million distinct bonds.

So when does it make sense buy muni bonds instead of taxable bonds? That depends largely on your personal tax rate. Because muni bonds are tax free, they generally provide lower yields than a government or even corporate bond with similar credit risk and maturity. Muni bonds are compared to Treasury bonds using a concept called Taxable Equivalent Yield, which allows you to compare bonds with different tax characteristics like U.S. Treasuries and muni bonds.

The rule of thumb for figuring the taxable equivalent yield of a muni bond is the yield divided by one minus your marginal tax rate. Your marginal tax rate is basically your tax bracket, or the amount of tax you would pay on your next dollar of income. Notice that the higher your tax rate, the better the taxable equivalent yield becomes. Notice also that it changes with both the yields on the bonds and your income tax rate. Muni bonds might make sense for an investor who is in a high tax bracket while working, but not for that same person once he or she retires.

Next month, I’ll cover ways to invest in muni bonds.

This column is prepared by Rick Brooks, CFA, CFP®. Rick is Vice President for Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Rick can be reached at (858) 755-5166, or by email at Rick and his family live in Mission Hills.

Rick Brooks

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