Municipal Bonds: A Great Way To Make Tax-Free Money

by: Mike the PhD

Overview of Municipal Bond Market

Municipal bonds represent a huge asset class (~$3.5 trillion in outstanding bonds) that gets relatively little attention in the financial press, so I thought it was worth go into an overview of this area. This overview paves the way for future posts where I will detail some statistical analysis related to predicting municipal financial distress, and financial returns to muni bonds.

Muni bonds are bonds that are issued by local and state governments or government backed entities (port authorities, school districts, etc). They are usually fixed rate bonds, and they have a wide range of maturities from 1 year out to as long as 30 or even 40 years. So pretty straight forward, and if that's all there was to municipal bonds they would usually be lumped in with corporate bonds, but there are three important characteristics that make municipal bonds unique from most or all of the other bonds (or even investments) out there.

First, municipal bonds are federally tax-free, meaning that you pay no federal income taxes on any of their coupon payments. In fact, if a municipal bond is issued by the state that you live in, you also don't pay any state income taxes either. So a New York resident with New York State municipal bonds would pay no federal or state income taxes on the coupon payments from those bonds. There is no other investment category that is completely tax free like that. This has the effect of making municipal bonds a really good deal for investors who are in the upper tax brackets. It's also why something like 2/3 of all municipal bonds out there, are held by individual investors.

So a municipal bond with a tax-free 5% yield to maturity is the equivalent of a corporate bond paying a lot more. For example, if you are in a 35% income tax bracket, then the return you get on a 6% taxable bond is only 3.9% after taxes (6%*(100%-35%) = 3.9%). Long story short - when you start looking at the numbers, muni bonds are often a better deal for income individuals than most of the regular corporate bonds out there. This is particularly true after you take into account the second defining feature of muni bonds.

The second characteristic of muni bonds is that they default at much lower rates than corporate bonds. Muni defaults are extremely rare both because most of the issuers are local governments, and a local government can't go out of business, and because many muni bonds are backed by insurance provided by insurance companies.

Investors don't pay for this insurance directly, and they don't have a choice whether they want it or not. Instead, the bond either has insurance when it is issued by the municipality or it doesn't. If the municipality runs into trouble and can't pay the bond holders, the insurance company is supposed to step up and pay the bondholders in place of the municipality.

It's important to realize though that while municipal bonds as a group are very safe, there are a lot of exceptions within that group. For example, municipal bonds issued by hospitals or nursing homes are a lot riskier. Municipal bonds which aren't rated by one of the three rating agencies (Moody's, S&P, and Fitch) are also riskier. Because of that extra risk, investors can frequently get really good interest rates on those bonds, but it is important to know which bonds to buy and which to avoid in those groups. So you want to talk with an expert and have them look at the specific muni bonds you are buying before you actually buy them. That's especially important with muni bonds because of their third defining characteristic.

The third characteristic of municipal bonds is that they are very illiquid and the market for them is vast. There are actually more municipal bond issuers than there are publicly traded corporations… by a lot. There are roughly 8,000 publicly traded companies in the US. There are roughly 80,000 municipal bond issuers. These issuers all issue municipal bonds with a variety of maturities, with different assets backing them, and they issuer them in different years.

The result is that for most municipal bonds out there, once you have bought the bond, it is very hard to sell it back if you decide you don't want it anymore. It's like buying a house or a car. If you want to sell a house or a car, it's going to take a while, it will probably be a bunch of work for you, and the transactions costs are going to be pretty steep. Now if you are just interested in holding the bond to maturity, that illiquidity doesn't matter much - the bond will pay you your interest payments and at maturity you get your money back. But if the bond issuer gets in trouble and you decide you want to bail early, that can be anywhere from somewhat tough to basically impossible. So again, before you buy a muni bond, make sure you read over the municipalities financial statements and think about the risks, or get a financial expert to do it for you and give you his opinion.

So that's a basic introduction to municipal bonds. They can be a really great investment with really high returns if you are a high net worth person, and they are usually very safe, but you have to be aware of the liquidity problems. I'll talk more about muni bonds in a future post, but this is enough for now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.