No investment, including municipal bonds, is appropriate for every investor. Before purchasing, consider their advantages and disadvantages to see if they are appropriate for your portfolio.
Some of the advantages include:
- Municipal bond interest income is generally exempt from federal, and sometimes state and local, income taxes.
Your marginal tax bracket is a major factor when deciding whether to invest in municipal bonds. Thus, you should compare a muni bond's yield to the after-tax yield of a comparable taxable bond. To do that, calculate the muni bond's taxable equivalent yield. If you're not investing in a municipal bond issued in your resident state, the calculation is: the taxable equivalent yield equals the tax-exempt interest rate divided by one minus your marginal tax bracket. For instance, if you are considering a municipal bond with a yield of 4.5% and you're in the 25% tax bracket, the taxable equivalent yield is 6.0% (4.5% divided by 1 minus 25%).
- A wide variety of bond choices exist.
With over 1.5 million municipal bond issues outstanding, you can find bonds with all kinds of different characteristics.
- Muni bonds typically have high credit ratings.
Municipal bond defaults are rare, but they do occur. Make sure to review the credit quality carefully before investing. You may want to stick with investment grade ratings, which is an indication that the issuer is considered financially stable and unlikely to default.
- Many municipal bonds are insured.
About half of all muni bonds are insured. The bond issuer purchases the insurance when the bonds are brought to market, with the insurance company committing to make timely payment of principal and interest in the event of the bond issuer's default. When the bonds are insured, the bond issue receives the same rating as the insurance company's rating, typically AAA. In the event of default, the investors can look to the insurance company for the payment of principal and interest. Thus, investors should review the financial soundness of both the issuer and the insurance company. Keep in mind that insurance relates only to the timely payment of principal and interest and does not remove other market risks, such as interest rate fluctuations or early principal repayment.
Some disadvantages of muni bonds include:
- Muni bonds are not appropriate for all types of portfolios.
Munis should not be considered for individual retirement accounts (IRAs), 401(k) plans, or other tax-advantaged plans. Since municipal bond interest is already exempt from federal income taxes, you gain no further benefit from placing the bond inside a tax-advantaged vehicle. In fact, the interest income will ultimately be subject to ordinary income taxes when withdrawn.
- Municipal bonds are callable.
Most muni bond issues have call provisions, which allows the issuer to redeem the bonds before maturity. The exact provisions, however, can differ significantly between bonds, so carefully review these provisions before purchasing a bond. While you can't prevent an issuer from exercising a call provision, you can purchase bonds with call provisions most favorable to you. Early redemptions generally occur when market interest rates are lower than the bond's interest rate. Even though you receive the principal and possibly a premium, the money must then be reinvested at a time when interest rates are lower than that paid on the original bonds.
- Muni bonds are still subject to some taxes.
While interest income is typically exempt from federal income taxes, selling a bond before maturity for a profit will result in a taxable gain. Also, some bonds pay interest income subject to the alternative minimum tax (AMT). State and local taxes must also be considered if the bond is not issued in your resident state.