Suitability

Benefits

The benefits of municipal bonds are the same as other bonds, but with a unique twist. Municipal bonds provide income that is typically tax-free to investors. If a resident purchases a municipal bond, they generally avoid all forms of taxation on the bond’s interest.

Municipal bonds are generally safe, especially general obligation (G.O.) bonds. In fact, there were only 21 G.O. bond defaults from 1970 to 2016. The taxing authority of municipalities is a big benefit to investors. 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 are also beneficial for investors wanting to support their local area. Money lent to cities and states is used to directly benefit its citizens. Municipal investors can pat themselves on the back for funding their roads, schools, parks, airports, universities, economic development, and more.

Risks

While most municipal securities are safe from default risk, this isn’t always the case. While it’s very rare for general obligation (G.O.) bonds to default, revenue bonds face higher levels of default risk. In fact, revenue bonds default at roughly 13 times the rate of G.O. bonds. However, revenue bond defaults are still fairly rare in the grand scheme of finance.

Liquidity risk is much more common than default risk. Most municipal bonds are subject to a considerable amount of liquidity risk. In fact, many municipal bonds trade less than 50 times a year. To put this in comparison, the average daily trading volume for Treasury securities in 2018 was $547 billion!

The trading audience is what drives liquidity risk. If you try to sell a municipal bond from your city, who do you think you’re attempting to sell the bond to? Other residents of your municipality in most cases. Municipal investors don’t trade securities with a national or global audience like corporate and US Government security investors do. The overall size of the market is not what drives the liquidity risk of municipal bonds. The municipal market is huge - it was estimated at a size of $3.9 trillion in 2019.

Liquidity risk is especially apparent for smaller municipalities. For example, Wyoming had a population of 578,759 in 2019. While this sounds like a lot of people, how many of them trade municipal bonds? And for those that do, how many would be willing to trade when an investor needs to liquidate? Bonds from Wyoming, or especially cities or localities in Wyoming are subject to significant levels of liquidity risk. The smaller the municipality, the higher the liquidity risk.

The last risk to discuss relates to yield. We discussed the benefit of tax-free income from municipal bonds above, but this benefit doesn’t exist for free. The drawback of tax-free income is low yields. Issuers know they can offer their bonds at low yields because of the lack of taxes investors pay on the interest. While it’s not the most devastating risk, an investor in a low tax bracket should avoid municipal investments. Otherwise, they’re experiencing opportunity cost when other investments could pay them a higher after-tax return.

Typical investor

Municipal bonds are suitable for a very specific type of investor. Just like any other bond, investors seek income from municipal bonds. However, a unique factor influences the suitability of these bonds. Due to their tax benefits, municipal bonds have low interest rates and yields.

In order to justify the investment, an investor must be in a high tax bracket. With our progressive tax system, Americans have higher tax brackets when they have more reportable income. Investors shouldn’t consider a low-yielding municipal bond with tax benefits if the tax benefits aren’t worth it.

Investors in high tax brackets can obtain reasonable returns from municipal bonds. Let’s look at the following example:

A wealthy investor in the 37% tax bracket is considering a corporate bond yielding 7% or a municipal bond yielding 5%.

On the surface, the corporate bond seems better. However, the corporate bond is fully taxable and the municipal bond is tax-free (assuming the investor is a resident). To find the after-tax return of the corporate bond, you could do the tax-free equivalent yield formula:

$\text{TFEY}=\text{CY\hspace{0.33em}x (100\% -TB)}$

$\text{TFEY}=\text{7\% x (100\% -37\%)}$

$\text{TFEY}=\text{7\% x\hspace{0.33em}63\%}$

$\text{TFEY}=\text{4.4\%}$

Your guide:

$\text{TFEY}=\text{tax-free\hspace{0.33em}equivalent yield}$

$\text{CY}=\text{corporate\hspace{0.33em}yield}$

$\text{TB}=\text{tax\hspace{0.33em}bracket}$

When we remove the taxes from the corporate bond, we find it’s only providing an after-tax yield of 4.4%, which is below the 5% tax-free yield of the municipal bond. In this situation, the municipal bond is better for the investor, but only because of their high tax bracket. What if the tax bracket was 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?

As you can see, just a slight downturn in the investor’s tax bracket made the corporate bond a better investment. The after-tax yield of the corporate bond is better than the tax-free return of the municipal bond. Ultimately, municipal bonds are only suitable for those at high tax brackets.

We haven’t learned about them yet, but municipal bonds are also 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 make a return on their investments. Taxes are generally paid when the account owner pulls money out of the account in retirement.

Investors avoid municipal bonds in retirement accounts because of the tax shelter they provide. Why purchase a low-yielding, tax-free bond in a tax-sheltered account? You could purchase a higher-yielding corporate or US Government bond, both of which are normally taxable, and avoid the taxes in your retirement account.