At Moneta Group, we receive a lot of questions about bonds. One of the more common questions we get is, “Should I invest in municipal bonds or taxable bonds?” The answer, as with many investments, is all based on the individual’s circumstances and personal situation. For example, with the top federal tax bracket now at 39.6% and the 3.8% surtax on net investment income, tax considerations are significant. An investor in the highest tax bracket will typically benefit from municipal bonds; however, if you are in the 15% tax bracket, its taxable counterpart might make more sense.
Fortunately, there are several ways to determine which option may be the best for you. One method is to use a simple formula to calculate the tax-equivalent yield, or TEY, which is used to compare tax free returns of municipal bonds to those of taxable bond. As a rough estimate, the formula is:
Bond yield / (1 – your tax rate)
For example, if you were in the 39.6% tax bracket and the yield on a municipal bond is 4%:
4% / (1 – 0.396) = 6.62%
Thus, you would have to find taxable bond yields of 6.62% with the same maturity date to obtain the same equivalent yield (keeping in mind various credit risk factors as well).
If you were considering the same municipal bond, and you were in the 15% bracket, the impact would be as follows:
4% / (1 – 0.15) = 4.70%
A staggering difference indeed! TEY is simply one strategy to compare tax-free vs. taxable bonds. One should be cognizant of credit ratings, diversification and the impact of rising interest rates.
What to expect for municipals in 2015
Another question we have been asked more recently is, “Are municipals a good investment at this point in the rate cycle?” We believe the fundamentals of why an investor would hold municipal bonds are still prevalent: diversification, federal tax-exempt income and credit stability.
Last year was a solid year for municipal bond holders. Returns benefited largely from declining interest rates in 2014, to which came as a surprise to bondholders. As we look to 2015, we cannot ignore the giant elephant in the room of rising interest rate; however, a well constructed bond ladder aids in a rising interest environment allowing bonds which have been called or matured to be reinvested at higher rates. There are still some other challenges and concerns in the muni market that lie ahead to which we are keeping our eyes on:
- Moody’s recently downgraded the city of Chicago’s credit rating to Ba1 from Baa2 which is now considered junk status. Unfunded pension liabilities, Chicago Public Schools’ shortfall and the outstanding debt of the Chicago Park district and Chicago Transit Authority that taxpayers are on the hook for further complicate the problem.
- Puerto Rico bonds are teetering on the brink of default; however, the country’s bonds have rallied since May 14th when Governor Alejandro Garcia Padilla and lawmakers agreed on a tax plan to help balance their budget. With a deteriorating economy and unsustainable debt level, the island certainly has some significant challenges ahead.
Even if the Federal Reserve begins raising interest rates later this year, medium term municipal bonds may still be the prudent choice. Although it is true that most bonds lose value when interest rates increase, the markets will be very focused on the magnitude of the tightening. If the market feels that interest rates are going to go up slowly and in very small increments, price declines of municipal bonds may be slight. Moreover, bond holders will be earning tax-free interest as the Fed plots its course.
Ultimately, municipal bonds complement a well-diversified portfolio with an appropriate asset allocation based on the risk tolerance and investment objectives of the investor. We believe current municipal bond valuations are relatively attractive vs. other fixed income asset classes, but one should always work with their advisor to seek guidance for their overall personal financial picture.