In the current market environment it’s tempting to want to juice more yield from your bond portfolio. Especially because those with longer memories will notice that bond yields, though rising, remain low by historical standards. Often higher yields can come with a catch, namely that when you’re bumping up your yield, then you are probably also taking on more risk. However, in certain situations, owning municipal (muni) bonds can effectively increase your after-tax returns without necessarily adding more risk to the bargain. Munis can be thought of one of the few free lunches available when investing, this is due to munis’ tax treatment which we’ll explain.
This move to owning munis is only worth considering for taxable portfolios, especially if you’re in a higher tax bracket. If you have money in a 401(k), 403(b) or an IRA to name just a few tax-advantaged ways to save, then munis may offer little help. Equally if your tax rate is low, munis may not be worth the hassle and you can likely use tax-advantaged savings protects for virtually all your saving anyway.
The advantage of munis is that the interest isn’t taxed at the federal, and sometimes, the state level too. That’s good as you potentially pay less tax on your investments. However, if you’re invested in a 401(k) then you’re not paying investment taxes anyway, so munis aren’t too much use. As such, munis generally make the most sense for taxable accounts for higher income investors, particularly in higher-tax states, as that’s where they offer their greatest tax-advantage.
What’s The Risk?
Municipal bonds aren’t considered quite as low risk as U.S. Treasuries. Basically, the U.S. Treasury, should it need to, can print money to pay-off debt. Printing money is a great way to solve a host of financial problems. On the other hand, the entities that issue muni bonds, don’t have the same ability to print money should they need to. For example, Arkansas had to essentially restructure its state-level debt it 1933, it wasn’t quite a bankruptcy but it was close. Equally, in 2017 Puerto Rico restructured its debt and in 1994 Orange County in California declared bankruptcy after some unfortunate trading activity. Today there are concerns about the accounts of Illinois. The idea of any debt being truly risk-free is ambitious. Municipal debt is generally less risky than most. However, there have been a few episodes in history when muni bond holders didn’t get back what they expected. Muni debt is generally considered lower risk, but it is not risk-free. As always, spreading your bets through diversification may be a helpful technique.
The Wrong Way To Reach For Yield
As an alternative to munis, income starved investors can start to make potentially riskier trade-offs. For example, a U.S. Treasury bond pays around 3% yield today, but a diversified basket of emerging market debt pays 5% or so. Yet, there’s a need to be cautious here. A yield on a bond is just a promise to pay, not an iron-clad guarantee. The U.S. has historically been a relatively reliable borrower. However, as Bank of Canada research shows, there’s been at least one ongoing emerging or frontier market in default during each one of the past 30 years. That’s not to say that higher yield on emerging market debt is a bad deal, but you have to go in with your eyes open. Ultimately, it’s not an apples-to-apples comparison, the U.S. government appears highly unlikely to default, whereas some emerging market economies almost certainly will again. As a result, you have to be sure that the extra yield, of 2% currently, compensates you for any loses should certain emerging market economies end up not paying their debts in full and on time. A similar thing is true of corporate debt as well. Yes, corporations generally pay you back. Nonetheless, in every economic cycle a few companies, and sometime many companies in entire industries, fail to meet their debt payments. Again, you need to make sure that the extra risk you’re taking really is compensated for by that higher yield. So, the nice aspect of munis is yes, you’re getting more after-tax yield on your money. Yet, that’s coming primarily via the way munis are treated for tax purposes, not necessarily because you are taking on a greater investment risk by owning munis.
Which To Buy?
Exchange Traded Funds (ETFs) are one way to access a diversified portfolio of muni bonds. Both iShares and Vanguard offer low-cost muni ETFs containing a host of different bonds. The iShares National Muni Bond ETF owns over 3,000 bonds and its largest exposures are to California and New York, both currently representing about a fifth of the overall fund. Vanguard’s Tax-Exempt Bond ETF is perhaps slightly better diversified with over 4,000 bonds and slightly lower exposure to California, though the two funds should be considered broadly similar. Importantly, they are both low-cost funds, with the iShares fund at an annual expense ratio of 0.07% and Vanguard at 0.09%. That means you’re paying a holding cost of $7 to $9 respectively for every $10,000 invested per year. In the grand scheme of things, that’s inexpensive, though free funds are also now available for some asset classes.
One concept you must understand with munis is their tax-equivalent yield. Let’s say you have a Treasury bond and a muni bond, both pay you 4% interest. Note, I’m using simple numbers here, in reality rates are a little lower today. You’ll likely pay tax on the Treasury bond’s interest, but not the muni bond. So the value of the muni bond depends, in part, on your tax rate. If you pay a 25% rate of tax on your interest income from your bonds, then after-tax you’ll receive effectively 3% interest on your Treasury bond, but a full 4% on your muni bond because it isn’t taxed. Things are further complicated by state and local taxes, your muni bonds may be free from state and local taxes to the extent the bonds are issued by your state and locality. As you can see, the more tax you pay on your investment income, the better the relative yield on the muni bond looks. Plus, where you live has an impact too.
Options For California And New York Residents
Building on this taxation logic, there are also state-specific muni bond funds, for example the iShares California Muni Bond ETF or the iShares New York Muni Bond ETF. The expense ratios come in a little higher at 0.25% or $25 per $10,000 invested per year. However, you may save on State taxation too by owning these bonds. The trade-off is some loss of diversification. Some investors might consider large holdings in bonds issued solely by a single state too risky, despite the greater tax benefits on offer. If that’s the case you could combine a broad muni fund with your State-specific fund in a ratio that you feel comfortable with. Note that smaller or low-tax states may not have specific muni bond options, however certain other states have mutual funds branded ‘Municipal’ or ‘Tax Free’ that track their State’s muni markets. However, in many cases the expense ratio can nudge up to 0.50% or more, making them a little less desirable, as these higher fees can offset a decent chunk of the yields received on debt, making the returns after all fees are considered uninspiring.
Thus, muni bonds can be an option for your taxable portfolio. This is particularly true if you’re a bond-centric investor and fall under a higher tax bracket. Owning munis may improve your after tax returns slightly because of the tax advantages. However, munis should not be considered completely risk-free because historically there have been some states that were unable to pay their debts as expected, though these cases have been relatively rare.