Many investors consider municipal bonds (munis) to be a very safe and straightforward way to obtain tax free income and a good option for conservative investors with taxable accounts. But the issues involved in muni investing are more complex than most realize. For those not familiar with munis, these are bonds that are issued primarily by state and local governments and interest income is not taxed at the Federal level. In addition, if you buy a bond from an entity in your own state, the income is not taxed at the state level either.
One misconception is that all income and gains from munis are tax-free. While the income from coupon payments is generally tax-free, munis may still be subject to capital gains and even ordinary income taxes if the bond is purchased in the secondary market (i.e. not part of the original issuance by the state or local government). In addition, income from Private Activity Bonds, (which are bonds issued by state and local governments for the benefit of a private enterprise) while exempt from the regular federal income tax, is subject to the Alternative Minimum Tax. Finally, muni bond interest can also impact the level of social security income that is taxable for retirees.
Muni bonds are also subject to interest rate, default, call, and reinvestment rate risk, as are most other bonds. A risk that is often underappreciated is call risk. Many muni bonds have a call feature that allows the issuing entity to redeem the bonds early. When looking at the yields on muni bonds to purchase, you may come across a bond with a yield that is significantly higher than other comparably rated bonds. Often, the reason the yield is so high is that the market expects the bond to be called in well before maturity which will lower the yield you actually earn.
Default risk has garnered a lot of attention recently given the issues in Detroit and other municipalities across the nation that are in dire financial condition. To mitigate this risk you’ll want to buy a sufficient number of bonds from different issuers which can be expensive. One option to gain diversification inexpensively is to buy a muni bond fund instead of individual bonds.
The final issue related to purchasing individual muni bonds I wanted to discuss has to do with the transparency in the markups that broker/dealers earn when selling muni bonds. When you purchase a muni bond it appears that there is no commission or other fee that you have to pay. But in reality muni bonds are bought and sold by bond dealers much the same way used cars are bought and sold by car dealers. The dealer buy a bond for Price X, marks up the price of the bond and then sells it to an investor for Price Y. There is no requirement that these markups be disclosed and the markups vary widely by broker dealer. If you interested in purchasing individual muni bonds be sure to ask your broker about the markup the firm charges.
I hope this information helps to clarify the pros, cons and common pitfalls of investing in municipal bonds. If you are left with any lingering questions, don’t hesitate to contact me.