The Simple Five Minute Guide to Understanding Municipal Bonds

The Simple Five Minute Guide to Understanding Municipal Bonds

April 27, 2021

In a 2012 press release, the U.S. Securities and Exchange Commission (SEC) reported that, at year’s beginning, “there were more than one million different municipal bonds outstanding totaling $3.7 trillion.” Moreover, a good portion of that $3.7 trillion in bonds generated tax-exempt income at the federal, state, and local levels for its holders! Consequently, municipal bonds, or “munis,” may be effective tools in your wealth management arsenal, especially when it comes to retirement.

What are municipal bonds?

Many government entities at the local and the state levels allow individuals and corporations to lend them money to complete various projects for the public welfare. In exchange, they promise to pay the lender a specific interest percentage on the principal, most often every six months, for a specified duration of time. If the entity has not defaulted by the final payment date, called the “maturity” date, it then returns the principal to the lender, as well. As you can see, these investments can potentially offer quite a deal.

But how safe are they?

There are two primary ways to appraise the security of municipal bonds. First, every bond issuing entity posts “official statements” or “offering circulars,” which provide information related to its financial health status. You can find these through the Electronic Municipal Market Access (EMMA) portal, offered by the Municipal Securities Rulemaking Board (MSRB). According to the MSRB, established in 1975, its mission is “to protect investors, state and local governments, and the public interest.”

Also, each bond issuing entity earns a credit rating from rating agencies such as Fitch, Moody’s, and Standard & Poor’s. To generate income, focus on choosing bonds these agencies rate as “investment grade,” or those generally most apt to preserve your original investment and offer steady interest payments. Fitch and Standard & Poor’s “investment grade” ratings are BBB and higher, whereas Moody’s are Baa and higher.

Our financial services include helping you use both methods above to assess municipal bonds and find those that may reduce your risk and offer stable income.

Types of municipal bonds

There are generally two types of municipal bonds, which differ based on how they guarantee payments to bondholders.

Issuers of general obligation bonds, which are often approved by voters, usually use their taxing power to support their payment of interest and repayment of principal. On the other hand, issuers of revenue bonds, which are usually special entities created to discharge the specific obligations of the bond, finance their payments to holders through charging tolls at the facilities created by the bond–airports, toll roads, and bridges, to name a few examples.

Our personal financial advisors are happy to provide more information and advice on both types of bonds, including special investment features, as well as taxable municipal bonds.

Advantages of tax exemption

As seen above, municipal bonds come in a range of choices that, because of their issuance by taxing or public facilities entities, can normally create reliable and safer income. However, many municipal bonds also create tax-free income at some or all governmental levels, which can potentially yield higher returns than other investments.

The following scenario illustrates the potential advantages of tax exemption. Suppose that you and your spouse will file a joint return for 2016 claiming $175,000 in taxable income, which places you in the 28% bracket, according to estimates from The Tax Foundation. You have $25,000 to invest and are considering a taxable corporate bond that yields 8% annually and a tax-exempt municipal bond that yields 6% annually. The taxable corporate bond will generate $2,000 in annual income before taxes, but only $1,440 after taxes, whereas the municipal bond will generate $1,500 annually.

Over a five-year period, the municipal bond will generate $300 more than the corporate bond.

Bond comparisons differ for every case, so when it comes to which investments are best for your own personal finances, seek financial advice from a trusted professional, like our own private wealth management advisors. Book a meeting with us today to have a more in-depth conversation about the intricate world of municipal bonds and how you might potentially benefit from them.

The hypothetical example provided is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing. Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.

LPL Tracking: 1-05112370