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When You Should Hold Municipal Bonds in Your Portfolio (And Why!)

Written by:
PK

A municipal bond, often termed a “muni”, is a fixed-income instrument  issued by a local government, city, township or agency.

What are municipal bonds?

Municipal bonds are debt securities. When a municipality needs money for a specified purpose such as an infrastructure project, long-term investment or general financial and cash flow management they can issue a bond.

Municipal bonds have various maturities ranging from:

  • Short-term,
  • Less than 1-year
  • Long-term issues that can be 30-years or longer.

Like any loan, borrowers receive cash and the lenders (the bond investors) receive a promise of repayment at a specified time, as well as periodic payments.

In the U.S., interest income received by holders of municipals bonds is typically exempt from federal income tax and from state income tax.Tax-exempt status is one of the most attractive features of municipal bonds from an investors’ point of view.

When should you hold municipal bonds in your portfolio?

Municipal bonds make the most sense for an individual that has already maximized all other tax-efficient investment options.

In other words, if you have contributed the maximum permissible annual amounts to:

  • A pre-tax 401K plan
  • 529 College Savings Plan
  • IRA/Roth IRA
  • HSA
  • Or other tax advantaged investment (e.g. other deferred income or real estate investments)

then purchasing municipal bonds or municipal bond funds might make sense. When you reason through the other accounts, you'll find high new worth investors are the ideal target for municipal bonds.

Why are municipal bonds best for high net worth or affluent investors?

It's ridiculous to hold municipal bonds in your tax-deferred IRA. The main advantage of municipal debt is its tax-free advantage. If you hold the bonds in a tax-advantaged account, you are effectively “wasting” the tax-advantaged status of a security that's already tax-exempt.

Municipal Bonds: Spreads, 2-yr and 10-yr
Municipal Bonds: Spreads, 2-yr and 10-yr

Let me clarify with an example: Your tax-deferred 401k has an annual contribution limit. That limit serves to promote your own retirement savings... while balancing the government's need to fund everything it needs.

The government does not tax income received from interest, dividends and capital gains in your 401(k) until you retire and actually withdraw money. As an investor, tax-deferred accounts are powerful savings tool. The annual limit is in place to constrain that special benefit they give you.

The bottom line: your objective is to use your tax-deferred 401(k) capacity wisely. The wisest thing you can do is fill your tax-deferred 401(k) with taxable securities, such as equities and corporate bonds.

On the other hand, since the interest you receive from municipal bonds is tax-free there is no need to shield these securities from income taxes!

It's wise to hold your municipal bonds in taxable brokerage accounts because of this benefit. And, as stated above, it's best to do that after you've exhausted the limits on all your taxable accounts.

Should I buy municipal bonds directly or buy municipal bond funds?

Our view is that if you are new to municipal bond investing, purchase a municipal bond fund. Municipal bond funds come in a variety of forms such as mutual funds, exchange-traded funds, closed-end funds, and other, more exotic types.

The key benefits to investing in municipal bond funds are:

  • Outsourced management: Fund managers select the portfolio, and manage the purchase and sale of municipal bonds. Managers collect any interest payments and r-distribute income to investors in exchange for the fund's fees.
  • All-in-one diversification: Purchasing a single fund can provide exposure to municipal bonds issued by various cities or agencies across the U.S. Even without a ton of money, you can receive diversification by issuer, tenor, purpose, interest rates, credit ratings, repayment sources, collateral, and other metrics.
  • Less initial capital requirement: Municipal bond mutual funds usually have a minimum purchase amount of $1,000 to $10,000 for a portfolio of bonds. Municipal bonds are issued and traded in $5,000 denominations.

    You would need at least $50,000 to buy 10 different municipal bonds directly in order to build a portfolio. ETFs or Mutual funds give you diversity for less.
  • Funds (specifically ETFs) are traded on an exchange: Exchange traded funds unds can be sold easily and electronically through a discount broker just like placing an equity trade.

    However, if there was a material liquidity event in municipal bonds, your ability to execute fund trades would be impacted.
Various municipal bonds in mutual funds
Examples of a few municipal bond funds.

Should you buy municipal bonds now?

Like oh-so-many questions the answer is: “It depends on your situation and knowledge”.

Before you buy municipal bonds, here are some things to consider:

  • Spreads and prices have an inverse relationship; when spreads decline, bond prices normally increase.
  • If you expect increasing interest rates, they will decrease bond prices, thus deflating the value of fixed income holdings.
  • Municipal bonds and bond funds generate tax-exempt income, which is attractive even while yields are low.
  • In addition, municipals feature an extremely low default rate. They also have a distinct advantage over corporations in raising money: the ability to increase taxes.

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