Consider Munis for Tax-Free Income
Published: December 01, 2016
The city of Detroit’s 2013 bankruptcy and the continuing debt crisis in Puerto Rico have cast municipal bonds in a negative light for some investors. In general, however, “munis” are considered to be a relatively safe investment and more stable than corporate bonds. A 2015 study found that only 0.14% of municipal bonds default within 10 years, compared with 11.58% of corporate bonds.1
The troubles in Detroit and Puerto Rico have pushed some issuers to raise interest rates in order to attract investors, making this a good time to consider whether municipal bonds may be appropriate for your portfolio.
Munis are debt obligations issued by state and local government entities. They typically fall into one of two categories.
General obligation bonds are issued to raise capital immediately, usually to cover expenses or refinance public debt. They are commonly repaid through taxes levied by the issuing agency.
Revenue bonds are issued to fund specific revenue-generating projects, such as utilities, sports stadiums, redevelopment projects, and toll roads. Revenue bonds are typically repaid from the revenues generated by the finished projects.
The primary appeal of municipal bonds is that the interest is generally exempt from federal income tax, as well as from state or local taxes if you live in the state where the bond was issued. The tax-free yield may be higher than the after-tax yield on taxable bonds, especially for investors in higher tax brackets (see chart).
Risk and Ratings
Like all bonds, munis are rated for credit risk. A range of AAA down to BBB (or Baa) is considered “investment grade,” and lower-rated or “junk” bonds are considered to carry high risk. Some bonds may also be insured, with a separate credit rating for the insurer.
Municipal bond funds spread risk across many individual bonds. Some muni funds focus on bonds from specific states and may also include bonds from U.S. territories such as Puerto Rico and Guam that are not subject to state taxes, making the fund’s interest income tax-free for investors who live in the targeted state.
Keep in mind that if a bond was issued by a municipality outside the state in which you reside, the interest may be subject to state and local income taxes. If you sell a municipal bond for a profit, you could incur capital gains taxes. Some municipal bond interest may be subject to the alternative minimum tax.
The return and principal value of bonds and bond fund shares fluctuate with changes in market conditions. When redeemed, bonds not held to maturity and bond fund shares may be worth more or less than their original cost. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance. Investments offering the potential for higher rates of return involve a higher degree of risk.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.