Municipal bonds offer many of the same benefits as other bonds (especially steady income), but with an important difference: the interest income is typically tax-free. If you buy a municipal bond issued by your home state or locality, you generally avoid taxation on the bond’s interest.
Municipal bonds are generally considered safe, especially general obligation (G.O.) bonds. In fact, there were only 21 G.O. bond defaults from 1970 to 2016. A key reason is the municipality’s taxing authority. Taxes must be paid, and municipalities rarely default on bonds backed by taxes. Revenue bonds are also generally safe, but defaults are more common than with G.O. bonds.
Municipal bonds can also appeal to investors who want to support their local area. Money lent to cities and states is used to directly benefit citizens. Municipal investors can point to projects they helped fund - roads, schools, parks, airports, universities, economic development, and more.
While most municipal securities are safe from default risk, defaults can still happen. It’s very rare for general obligation (G.O.) bonds to default, but revenue bonds face higher levels of default risk. In fact, revenue bonds default at roughly 13 times the rate of G.O. bonds. Even so, revenue bond defaults are still fairly rare in the broader financial markets.
Liquidity risk is much more common than default risk. Many municipal bonds trade infrequently - often fewer than 50 times per year. For comparison, the average daily trading volume for Treasury securities in 2018 was $547 billion!
Liquidity risk is driven by the size of the trading audience. If you try to sell a municipal bond issued by your city, who are you likely selling it to? In many cases, it’s other residents (or local investors) who are interested in that municipality’s debt. Municipal investors typically don’t trade with the same national or global audience that corporate and U.S. government security investors do.
It’s important to separate market size from liquidity. The municipal market is huge - it was estimated at a size of $3.9 trillion in 2019 - but individual issues can still be hard to trade.
Liquidity risk is especially noticeable for smaller municipalities. For example, Wyoming had a population of 578,759 in 2019. Even if that sounds like a lot of people, only a small fraction trade municipal bonds. And among those who do, only some will be ready to buy at the moment an investor needs to sell. Bonds from Wyoming - and especially from smaller cities or localities within Wyoming - can be subject to significant liquidity risk. In general, the smaller the municipality, the higher the liquidity risk.
The last risk relates to yield. We discussed the benefit of tax-free income above, but that benefit comes with a tradeoff: lower yields. Issuers know they can offer lower yields because investors don’t pay taxes on the interest. This isn’t always a devastating drawback, but it matters. An investor in a low tax bracket should generally avoid municipal investments; otherwise, they may face opportunity cost if other investments could provide a higher after-tax return.
Municipal bonds tend to fit a specific type of investor. Like other bonds, they’re often used to generate income. The key suitability factor is taxes: because municipal interest is typically tax-free, municipal bonds usually offer lower interest rates and yields than comparable taxable bonds.
To justify accepting a lower yield, an investor generally needs to be in a high tax bracket. With a progressive tax system, higher levels of reportable income can push investors into higher tax brackets. If the tax benefit isn’t valuable enough, a low-yield municipal bond may not make sense.
Investors in high tax brackets can still earn competitive after-tax returns from municipal bonds. Consider this example:
A wealthy investor in the 37% tax bracket is considering a corporate bond yielding 7% or a municipal bond yielding 5%.
At first glance, the corporate bond’s 7% yield looks better. But the corporate bond is fully taxable, while the municipal bond is tax-free (assuming the investor is a resident). To find the after-tax return of the corporate bond, you can use the tax-free equivalent yield formula:
Your guide:
When you account for taxes, the corporate bond provides an after-tax yield of 4.4%, which is below the municipal bond’s 5% tax-free yield. In this situation, the municipal bond is the better choice - but only because the investor is in a high tax bracket. What if the tax bracket is lower?
An investor in the 25% tax bracket is considering a corporate bond yielding 7% or a municipal bond yielding 5%. What is the tax-free equivalent yield of the corporate bond?
Can you figure it out?
With a lower tax bracket, the corporate bond becomes the better choice: its after-tax yield (5.25%) is higher than the municipal bond’s 5% tax-free yield. Ultimately, municipal bonds are only suitable for those at high tax brackets.
We haven’t learned about them yet, but municipal bonds are also generally unsuitable for retirement plans. Retirement plans, like individual retirement accounts (IRAs), are tax-sheltered investment accounts. No matter what type of investment is in the account, the investor does not pay taxes at the time they earn returns. Taxes are generally paid when the account owner withdraws money in retirement.
Municipal bonds are usually avoided in retirement accounts because the account already provides a tax shelter. In other words, why buy a low-yield, tax-free bond inside a tax-sheltered account? Instead, an investor could buy a higher-yielding corporate or U.S. government bond (normally taxable) and still avoid current taxes because the retirement account shelters the income.
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