The tax-free income from municipal bonds can provide higher after-tax returns compared to corporate or treasury bonds for investors in higher tax brackets. For investors in the federal marginal tax bracket of 28% or higher, municipal bonds may provide a higher after-tax return. However, investors need to be aware of the risks associated with municipals; credit risk, term risk, liquidity risk, maturity risk, tax risk, and geographic risk.
Credit Risk
While lower grade bonds provide higher current income, it comes with a greater default risk. This additional risk of default relative to the slightly higher yield for lower grade bonds has not provided sufficient additional return to warrant the extra risk, particularly if an investor has risk exposure of more than 5% in any of their individual bond positions. Accordingly, investors should focus on the higher credit quality or insured bonds.
Term Risk
Investors should have an average maturity of no greater than five years. This is due to the fact that longer maturities incur incrementally greater volatility with only a very small increase in current yield.
Liquidity Risk
Municipal bonds have unique liquidity risks not associated with comparable quality corporate or treasury bonds. Due to their less liquid nature, municipal bonds have larger bid/ask spreads resulting in higher transaction costs, particularly for trades under $250,000. These higher costs are compounded by a lack of a centralized transparent trading venue, making it difficult for individuals to compare prices between dealers.
Tax Risk
Tax laws are constantly changing and are rarely predictable, especially over the long term. If, for example, top marginal tax rates rise, municipal bonds become more valuable. Conversely, if tax rates drop, those same bonds will see their value decrease.
Geographic Risk
Many municipal bonds? ability to pay is contingent on local municipal economic health. When a geographic area such as New Orleans is devastated by a hurricane or other natural disaster, municipalities? ability to pay their obligations becomes compromised. U.S. Government and corporate bonds have little or none of this risk.
Individual Bonds versus Bond Funds
The advantage of owning individual bonds is the total control of credit quality, maturity, and geographic diversification decisions. Depending on a client's portfolio size, diversification with individual bonds may be difficult or not cost-effective. Many investors may be better off owning a low cost, short-term municipal bond index fund, such as the Vanguard Limited Term Municipal Bond fund, which has a very low fee (as low as .11% annually), substantial diversification (over 700 bond issues), a 2.7 year duration, and no single bond issue representing more than 1% of the fund.
