Municipal bonds have long been a popular investment for higher-income Americans. Like other bonds they can play an important role in diversifying an investor’s portfolio, since they generate a steady stream of coupon income without the dramatic ups and downs of the stock market.
One of the most attractive features of municipal bonds or “munis” is that their income is generally exempt from federal income tax. That’s a major advantage for an investor in a higher tax bracket, and a key reason for adding munis to a diversified portfolio of assets. However, some bonds may be subject to the alternative minimum tax (AMT) but these bonds are clearly marked as such.
Let’s take a closer look at how munis provide that potential financial benefit, even though their stated returns appear lower than corporates or other types of bonds. Let's say you purchased a taxable bond with a 6 percent return. If you were in the highest federal tax bracket (39.6 percent for the 2014 filing year), you would have lost about 2.4 percent of those returns to Uncle Sam. The tax impact would be even greater if you had to pay state or local income tax, where applicable, on top of your federal taxes.
Therefore, a tax-free muni bond would only have to have a 3.6 percent yield to match that 6.0 percent taxable rate. So, if you could invest in a muni that paid 4 percent, for example, and you were in the highest tax bracket, it would be advisable to pick up those munis (all other considerations being equal).
There are two reasons that high-income investors should consider adding munis to their portfolios this spring. First, the American Taxpayer Relief Act of 2012 raised marginal tax rates for wealthy individuals and couples, who may now face an even more hefty “tax bite” next year.
Second, there is a growing movement in Washington to reform the nation's tax system. The overall goals include creating a simpler tax environment, eliminating wasteful tax “loopholes” and increasing the flow of revenue to the government. The specter of a tax policy change that may diminish or eliminate the municipal tax exemption has cast a shadow over the muni market in recent years and has frequently driven munis to trade cheaper on a relative value basis than historical norms.
Because this is an election year for Congress, it's highly unlikely that anything will happen to change the tax climate until 2015. But if momentum grows for tax reform, it's possible that municipal bonds could lose their tax-exempt status.
If that were to occur in the next few years, it would be uncertain whether currently outstanding bonds would retain their tax benefits, but coupon income from new bonds issued by states, cities, counties or municipal agencies would become partially of fully taxable.
Since municipal bonds are usually a long-term "hold" for many investors, it's important to look at least several years into to the future when evaluating the risk factors. Certainly, there appears to be at least a possibility that Congress might change the landscape in regard to munis, making them far less attractive to some investors.
Of course, there are other issues to consider before buying municipal bonds. As with other types of securities, munis have different risk-reward profiles, based on the issuer, the type of bond and other economic and financial factors.
For example, some municipal governments have strong management and robust tax bases, which may reduce the risk of a default on municipal bonds, while others use dedicated revenue sources to finance water and sewer systems, bridges and highways, hospitals or other infrastructure projects. It is also possible that some municipalities may run into financial difficulties in the future, increasing the risks to investors. Therefore, you should review the credit rating and reports on municipal bond issuers before making a purchase decision.
Investors should also look at the different types of munis currently offered in the market. For example, some issuers offer general obligation bonds that are backed by the “full faith and credit” of the municipality. In other cases, investors can purchase revenue bonds that are secured by the funded project, such as a toll road or airport fees.
Another risk to consider is inflation. The majority of municipal bonds are fixed-income securities, meaning their rates typically will not rise or fall with changes in the nation's inflation rate. Therefore, if you expect inflation to increase significantly in the next decade, you may want to limit your purchases of munis, or other types of fixed-income securities. Bonds can also be subject to "call" risk (early redemption). When interest rates fall, an issuer may choose to refinance the bonds at a lower interest rate and in turn, “call” or redeem its previously issued bonds. As a result, an investor may have to reinvest the proceeds at a lower interest rate.
Because the future is always uncertain, investors should strive to build a diversified portfolio with assets that can grow in an inflationary environment, such as stocks and real estate, as well as assets like bonds that provide stability along with a steady, predictable return. In today’s tax environment, high-income investors should pay close attention to the role that municipal bonds can play in their portfolios.