Municipal bonds are gaining popularity among investors seeking tax-exempt income, but investors should be cautious about making investment decisions solely on the basis of tax savings. This week, Wells Fargo Investment Institute highlighted the appeal of municipal bonds as the Federal Reserve prepares to cut interest rates. When yields fall, bond prices rise, and when interest rates fall, municipal bond prices rise. “We view municipal bonds favorably, both mandatory revenue and general obligation, as they have historically performed reliably during times of economic uncertainty,” Wells Fargo said in a report this week. “For investors with high effective tax rates, we believe municipal bonds are an important part of the fixed income position.” But here investors can make a mistake and miss out on valuable income opportunities. Municipal bonds generally generate income that is exempt from federal income taxes and, if the investor resides in the issuing state, also exempt from state taxes, but they offer lower yields compared to other bonds. This is the trade-off investors make in exchange for the safety of general obligation bonds, which are backed by the full faith and credit of the issuing municipality. Even exchange-traded funds that hold muni bonds offer lower 30-day SEC yields compared to corporate bonds: The Vanguard Tax-Exempt Bond ETF (VTEB) has a 30-day SEC yield of 3.64%, while the Vanguard Total Corporate Bond ETF (VTC) has a 30-day yield of 4.17%. “Municipal bonds aren’t always the best option,” says Nisha Patel, senior portfolio manager at Parametric Portfolio Associates. “There are muni bonds out there that offer lower yields.” [tax] In fact, Parametric launched a service for financial advisors earlier this year to build tax-optimized bond ladders based on an investor’s specific tax bracket. Knowing your tax bracket A general rule of thumb is that if your marginal tax rate is 24% or higher, municipal bonds are a better candidate. When it comes to municipal bonds, the higher the tax bracket, the more valuable your tax-free income is. Consider that if a taxpayer in the 32% federal income tax bracket buys a municipal bond with a tax-free yield of 3%, they would need to find a taxable bond with a yield of 4.41% to earn the equivalent income, according to New York Life Investments. This is called the taxable equivalent yield. Investors in lower tax brackets may be able to earn more after-tax yields in the corporate bond space, even if the interest rate is 3%. Since income from corporate bonds is taxed at the same rate as ordinary income, taxation may not squeeze their returns as much. “The idea that you don’t have to pay taxes can blind investors to the idea that you could put money into other investments and pay the taxes and end up with more money left over,” said Colin Martin, a fixed-income strategist at the Schwab Center for Financial Research. “You might be able to get a higher after-tax yield on something like a corporate bond,” he added. Treasury bonds are another consideration for investors, as they offer interest income that is subject to federal taxes but exempt from state and local taxes. A Tax-Aware Approach to Fixed Income You don’t need to hold a lot of municipal bonds to get the best yield in your tax scenario. Here’s where to start. Think about your time horizon and effective tax rate. You might be in a high tax bracket now, but whether it makes sense to hold a lot of municipal bonds will depend on how things change. “If you’re paying taxes at the highest marginal tax rate, but you’re planning on retiring in three years and will have no salary at that point, your marginal tax rate goes down,” says Michael Carbone, a certified financial planner and financial advisor at Eppolito Financial Strategies in Chelmsford, Massachusetts. In that case, the taxable equivalent yields on municipal bonds may have seemed promising in high-income years, but become much less attractive when income drops. Consider where you store these bonds. Save money on taxes by storing your bonds in the right accounts. Municipal bonds are good candidates for taxable brokerage accounts, where investors can benefit from tax-free income. Companies and funds that hold them, especially with their higher yields, may be better suited to tax-deferred accounts such as individual retirement accounts, given the tax treatment of interest income. If you’re looking for tax-conscious funds, do your homework. Some fund families offer “tax-conscious strategies” in mutual funds or ETFs, which may include exposure to municipal bonds as well as stocks. While these options can help investors save on taxes, investors need to understand what’s included in these portfolios and what the costs are. “As you spend more time understanding these tax-sensitive strategies that have emerged over the last five years, you’d better understand what’s in your portfolio and where risks may surface,” says Beth Foos, associate director of fixed income strategies at Morningstar. “It’s really important to look at the fees and understand how they affect your results.”
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