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 at 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 at 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.