Municipal Bonds – Tax Free or Tax-ing?
By Rich Topps, Sr.
Should You Invest in Municipal Bonds (Munis)?
Generally, if you have the need for fixed income instruments (bonds) in your investment mix and you’re in one of the upper Federal Income Tax brackets, municipal bonds are worth considering. Munis are issued by municipalities (states, counties, cities, etc.) or other tax-exempt entities to finance various projects. Interest you receive on munis is exempt from Federal Income Tax and, in some cases, state or local income tax.
Types of Municipal Bonds
There are basically two types of municipal bonds: General Obligation Bonds (GO’s) which are backed by the full faith, credit, and taxing authority of the issuer; and Revenue Bonds on which the payment of interest and repayment of principal depends solely on the collection of a specified fee. A GO might be issued to build a school or library, and be repaid from property taxes. A Revenue Bond might be issued to finance a toll bridge or parking facility, and be repaid solely from the tolls or parking fees collected. For these reasons, GO’s are generally considered safer investments than Revenue Bonds.
It is wise to invest only in municipal bonds that are rated by the major rating agencies and deemed “investment grade” (as opposed to “junk bonds”). Many munis are also insured. In these cases, it’s important that the insuring company is also rated “investment grade”. Some munis may be subject to Alternative Minimum Tax (AMT), which is a Federal Income Tax quagmire best to be avoided by most investors. It’s also a good idea to diversify holdings by geography so that a localized natural disaster or financial crisis does not affect your entire portfolio. As with any debt obligation, the issuer’s creditworthiness needs to be monitored and call protection (whether the bonds may or may not be redeemed prior to their maturity date) needs to be considered.
A financial advisor with expertise in municipal bonds can prove to be invaluable. He or she can ensure that your portfolio is appropriate for your situation and also monitor ongoing events affecting the issuers of your bonds. Recently, for example, the city of Detroit filed for bankruptcy protection. Many experts have also expressed concern about the ability of the city of Chicago and the state of Illinois to repay future debts and one major rating agency has recently downgraded Chicago’s debt to “junk” status.
These actions came as no surprise to experienced municipal bond professionals who have timely access to information such as whether an issuer is being considered for ratings upgrade or downgrade, whether its outlook is improving or deteriorating, and whether it has submitted all required financial reports on time. All of this is information that the typical investor is unable to access and properly monitor – so it’s best to have a pro on your side.