With continued fluctuations in the stock market and bank CD rates rates at almost an all-time low, one of the most common questions currently being asked is whether or not one should consider a tax-free investment, i.e. municipal bonds as a viable alternative. But wait. Haven’t you heard about “Muni-geddon”? Yes. In 2010, there were widespread predictions of municipal bond defaults. However, even though there have been a few defaults, the forecasted wave of defaults failed to materialize. In fact, lately municipal bonds have generated the highest after–tax total return of any fixed–income sector. Muni-bond investors have realized anywhere from 20 to 50 basis points of additional return which can make a significant difference over many years. So it may benefit us to explore further the possibility of investing in municipal bonds.
The first two factors to consider are: your investment objectives and your marginal tax rate. Assuming that a tax-free investment could fit into the parameters of your investment plan, the next step is to determine if the yield/return would be favorable.
There is a simple formula which will help you to analyze tax-free yields. Simply divide the tax-free yield by 100 minus your marginal tax rate. This will enable you to convert the tax-free yield into its “taxable equivalent” yield. Let’s look at an example. Suppose that you are in the 28% tax bracket, and you can purchase a tax-free bond yielding 5%. Would that be a good deal? One way to find out is to use the formula and calculate the tax-free bond’s taxable equivalent yield. Here’s how to do it: you would divide 5 (the tax-free yield) by 72 (100- marginal tax rate of 28). The result would be 6.94%. This means that you would have to find a taxable investment such as a bank certificate of deposit (CD) yielding 6.94% in order to receive the same after-tax return that the 5% tax-free bond would provide. I don’t know of any CDs paying anywhere near that amount. Needless to say, the higher your marginal tax rate, the more attractive tax-free bonds become.
Municipal bonds are the only true “tax-free” investment. The most common ways that they may be purchased include individually, in an open-end or closed-end fund, in an electronically traded fund (ETF) or in a unit trust. There are certainly other factors one should consider before purchasing municipal bonds, such as the quality of the bonds, their rating, whether or not they are insured, their maturity date, if they are callable, and of course your own tolerance to interest rate fluctuation and default risk. While municipal bonds do fluctuate in value with the rise and fall of daily interest rate movement, that doesn’t affect the interest you’re getting paid, and at maturity you will receive all of your principal back.
Since everyone’s tax and investment situation is unique, I certainly recommend that you consult your investment and/or tax advisor before making a final decision.
The One Minute Investor, 2nd Edition