Municipal Bonds : Yields a Renaissance of Tax-Free Income

Alan Appelbaum

October 20, 2022

Municipal Bonds

If you’re considering investing in municipal bonds, you should know that you’ll benefit from tax-free income. Municipal bonds are tax-free federally, and some states also exempt them from local taxes. Additionally, the interest rates on these bonds are generally lower than taxable ones. Moreover, your payments from municipal bonds will not be subject to federal income taxes or alternative minimum taxes. This tax-free income can be especially beneficial for retirees who want to preserve every last dollar in their portfolio.

Tax-exempt bonds yield tax-exempt income.

Despite the recent decline in the prices of municipal bonds, the yields remain attractive. Moreover, municipal bonds are exempt from federal taxes, unlike many other investments. In May, they briefly caught up with the yields on U.S. Treasury securities. However, investors should be aware that rising yields often result in falling prices. As a result, the value of your investment may fall this year.

Municipal bonds are often issued by state or local governments or entities created by the government. In exchange for their tax-exempt status, the interest income on these securities is not subject to federal taxes. Some bonds are also tax-free in state or local jurisdictions. Municipal bonds may also be subject to alternative minimum tax rules.

As of July 31, nominal municipal bonds offered a yield to maturity of 2.79%. This was attractive from a historical perspective and relative to other bond sectors. Moreover, the AAA Muni yield/Treasury ratio is 97%, which makes tax-exempt debt especially attractive at the long end of the yield curve.

Tax-exempt bonds pay lower interest rates than taxable bonds.

Tax-exempt municipal bonds are bonds issued by governments for specific purposes. They are generally exempt from regular federal income taxes and offer higher yields than their taxable counterparts. Tax-exempt bonds, also known as “GOs,” are backed by the full faith and credit of the issuer. As such, GO bonds pay their interest first before any other obligations.

However, despite the relatively low-interest rates, taxable municipal bond yields have been under pressure throughout the year. This is likely due to the Fed’s aggressive rate-hiking campaign. As a result, the Bloomberg Taxable Municipal Index credit spreads have tightened since late May and peaked in May, reaching +123 BPS. These credit spreads are closely related to the volatility of U.S. Treasury rates and should improve once interest rates stabilize.

While most municipal bonds are tax-exempt, not all of them are. Some are taxable, like bonds used to finance public pensions and sports facilities. However, most are exempt from federal income tax, but they are subject to capital gains tax if sold at a profit. Municipal bonds are risky investments, and the issuer may not be able to meet their interest payments on time. For this reason, the creditworthiness of these bonds is evaluated by rating agencies.

Investing in muni bonds can lower interest-rate risk.

One of the best ways to minimize interest rate risk is to invest in municipal bonds. This have consistent and predictable income over time. In addition, they offer investors the benefit of diversification. Because interest rates move in opposite directions, bonds’ prices rise when interest rates fall and vice versa. However, rising rates haven’t caused municipal bond prices to drop in recent cycles. However, each cycle is different, so you should never wait to invest in Munis because you’re worried about rising rates.

There are two main risks that investors should be aware of when investing in muni bonds: the risk of default and interest rate risk. If you’re concerned about the risk of default, it’s best to investigate the municipality’s credit rating and the ratings of other bonds. In addition, the Municipal Securities Rulemaking Board, a regulatory body, maintains a website that provides useful information about muni bonds. Moreover, muni bonds tend to have inverse relationships with interest rates. Therefore, they generally fall in price when interest rates increase. Currently, they are in a bear market.

Investing in municipal bonds should also be considered a defensive strategy. After the financial crisis, muni bonds were considered to be low-yielding investments. However, the recent rebound in the U.S. economy has changed this perception. Today, investors can take advantage of the low-interest rates to protect their investments and minimize their exposure to interest rate risk. However, this strategy can have the opposite effect, as the risks of falling interest rates may be higher than the returns on the investments in muni bonds.

Municipal bonds generate tax-free income.

Municipal bonds have become a popular way for investors to achieve tax-free income through the compounding of returns. These investments, also known as “munis,” typically generate higher after-tax returns than comparable taxable investments. Furthermore, their interest is generally free of federal and state taxes.

Municipal bonds are typically tax-free on the federal level and may be tax-free on state and local levels as well. Tax-free income from municipal bonds is also attractive to investors who may have higher expenses during retirement. In this scenario, the tax-free income from bonds may make sense if you are concerned about saving money for health care.

However, there are some drawbacks to municipal bonds and may not provide the best return on investment despite being tax-free. As such, you must do your due diligence to ensure you get the most out of your money. An alternative to this is to invest in bond mutual funds or ETFs.