Should You Invest In Munis?

Alan Appelbaum

January 1, 2023


Municipal bonds are among the many investment options available for investors. They can be purchased through the stock market and are often tax-exempt. However, many different factors should be considered before investing in these bonds. Some of these include the rise in interest rates, liquidity risk, and the potential for tax minimization.

Tax-exempt yields

In today’s environment, the federal government’s fiscal stimulus has bolstered the municipal credit market. This is because municipal bonds are exempt from both federal and state taxes.

While this does not guarantee that a muni bond is free of tax, it is the case. As a result, this is an excellent buying opportunity for income-focused investors. However, it would help if you did not rely solely on this bond category to make investment decisions.

There are several other considerations to keep in mind when buying a municipal bond. Aside from the usual tax issues, you should also consider the financial details of the issue. If you have questions about the muni biz, consult a tax advisor or the IRS.

One of the most significant benefits of a tax-exempt muni bond is its yield. For example, a 4% tax-exempt bond offers a TEY (taxable equivalent yield) of 6.15%. Compare this to a taxable investment that needs to produce a 7.9% return to match the TEY of a municipal bond fund.

Tax minimization benefits

Tax minimization is an important part of investing. Keeping an eye on the tax impact of your investments can help you increase long-term wealth and spendable income.

Investing in tax-exempt bonds can be a smart move. There are several reasons to make this choice. The biggest benefit is the tax-free interest on these bonds.

The municipal bond market has been working well for decades. In 2012 alone, over $3.7 trillion in outstanding bonds were traded daily. However, the tax exclusion for municipal bonds has a downside. It shuts out some investors from the municipal bond market and delivers a smaller benefit to lower tax brackets.

However, this doesn’t mean the municipal bond market is not good. Municipal bonds can offer high returns to investors willing to accept higher borrowing costs.

The current tax treatment of tax-exempt municipal bonds is inefficient. For every dollar of taxpayer-subsidized borrowing, state and local governments get less than a dollar in savings.

Munis – Liquidity risks

The liquidity risks of investing in municipal bonds vary depending on the investor’s risk tolerance and investment objectives. However, the main risk affecting a bond’s value is the interest rate. If the rate goes up, the value of a bond is expected to fall.

If the rate goes down, a bond’s value is expected to increase. However, the price of a muni bond tends to go down if the news of a municipal bond default comes out. Other factors affect the muni bond’s value.

Investors are encouraged to diversify their fixed-income holdings. They can buy bonds with a higher interest rate or high-quality securities with good credit. Investing in various bonds can help mitigate the interest rate risk.

Investing in a muni ETF can also reduce the interest rate risk. These funds are generally less expensive than actively managed mutual funds. In addition, they provide intra-day tradability and greater transparency.

Munis – Rising interest rates

Municipal bonds can be an asset class with many compelling opportunities for investors. However, it’s important to realize that municipal bond prices may decline when interest rates rise.

Generally, longer-term muni bonds have outperformed short-term munis during rate hikes. Fortunately, there is a broad range of muni maturities to choose from. Higher-quality munis, especially those issued by high-rated municipalities, offer a good risk-reward profile.

Longer-term munis have gained during the economic recovery. They provide a higher yield than shorter-term munis but have less duration.

The Fed has raised interest rates, which raises the risk of price declines. However, favorable supply and demand dynamics in the near term should help support muni prices.

A healthy labor market and a relatively healthy consumer may temper inflation. Taxes are another tailwind for munis. Despite recent volatility, investors continue to see a return of positive net inflows into the muni bond sector.

Some investors favor short-term munis. The available tax-exempt supply may limit the risk of price declines.