Municipal bonds: Difference between revisions

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'''Municipal bonds''' are bonds issued by states and local governments.
'''Municipal bonds''' are bonds issued by states and local governments.


==Types of municipal bonds==
==Types of municipal bonds==
*'''General Obligation Bonds''' are municipal bonds secured by the taxing and borrowing power of the municipality issuing it.<ref>[http://www.investorwords.com/2165/General_Obligation_Bond.html General Obligation Bond definition at ''Investor Words'']</ref>
*'''General Obligation Bonds''' are municipal bonds secured by the taxing and borrowing power of the municipality issuing it.<ref>[http://www.investorwords.com/2165/General_Obligation_Bond.html General Obligation Bond definition at ''Investor Words'']</ref>
*'''Revenue Bonds''' are municipal bonds supported by the revenue from a specific project, such as a toll bridge, highway, or local stadium.<ref>[http://www.investopedia.com/terms/r/revenuebond.asp Revenue Bond definition at ''Investopedia'']</ref>
*'''Revenue Bonds''' are municipal bonds supported by the revenue from a specific project, such as a toll bridge, highway, or local stadium.<ref>[http://www.investopedia.com/terms/r/revenuebond.asp Revenue Bond definition at ''Investopedia'']</ref>
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==Taxation==
==Taxation==
===Interest===
===Interest===
 
Interest from municipal bonds is generally exempt from federal income tax and the issuing state's income tax.<ref group="note">States with no income tax do not impose taxes on municipal bonds.</ref> However, there are a few exceptions.  
Interest from municipal bonds is generally exempt from federal income tax and the issuing state's income tax. However, there are a few exceptions.


* Interest from some municipal bonds is subject to [http://www.irs.gov/taxtopics/tc556.html Alternative Minimum Tax (AMT)] although whether you actually have to pay AMT depends on your individual circumstances.  Such bonds are commonly referred to as AMT bonds.
* Interest from some municipal bonds is subject to [http://www.irs.gov/taxtopics/tc556.html Alternative Minimum Tax (AMT)] although whether you actually have to pay AMT depends on your individual circumstances.  Such bonds are commonly referred to as AMT bonds.
* Some states charge income tax on interest from their own municipal bonds.
* Some states charge income tax on interest from their own municipal bonds.
Areas of note:
* '''Puerto Rico, Guam, and US Virgin Islands:''' No state can tax bond interest issued by US territories.<ref name="muni">[http://www.municipalbonds.com/education/read/113/tax-exemption-from-state-income-taxes Tax-Exemption from State Income Taxes], from [http://www.municipalbonds.com/about/ MunicipalBonds.com]</ref>
* '''New York City:''' Bonds issued in NY may be triple tax-exempt from city, state, and federal income taxes.<ref name="muni" />
* '''Utah:''' Utah reciprocates taxation. Utah does not tax its own bonds, but also does not tax bonds issued in states that do not tax Utah bonds.<ref name="muni" />
* '''Washington D.C.:''' Does not tax in-state or out-of-state municipal bonds.<ref name="muni" />


===Capital gains/losses===
===Capital gains/losses===


Capital gains and losses are subject to taxation.  One notable point is the treatment of short-term capital losses. If you have short-term capital loss due to tax-exempt interest from a mutual fund held less than 6 months or less, you cannot claim the loss. You can still claim a part of the loss due to market movements, such a rising interest rate. See [http://www.irs.gov/publications/p564/ar02.html Publication 564 (2007), Mutual Fund Distributions] and [http://www.fairmark.com/mutual/stcl.htm Short-Term Capital Losses] for more details.
Capital gains and losses are subject to taxation.  One notable point is the treatment of capital losses for a holding period of less than six months. For an [[ETF]] holding bonds (but not for a traditional mutual fund if the fund accrues dividends daily and pays them at least monthly, as most bond funds do), if you received exempt-interest dividends, at least part of your loss is disallowed. You can deduct only the amount of loss that is more than the exempt-interest dividends. Report the loss as a short-term capital loss. See [http://www.irs.gov/publications/p550/ch04.html#en_US_2012_publink100010561 Publication 550 (2012), Investment Income and Expenses] and [http://www.fairmark.com/mutual/stcl.htm Short-Term Capital Losses] for more details.
 
{{Notice|''Example''<br> Assume that an investor purchases $10,000 of a tax-exempt bond ETF. Five months after purchase, the net asset value of the fund has dropped and the investor has a $200 short-term loss. Over this five month period, the investor has received $125 dollars of tax-exempt income. The investor must increase the sales price ($9800) by the the dividends received. The adjusted basis of $9925 results in a deductible $75 short term loss.}}
 
===Social Security===
Municipal bond interest is included in modified adjusted gross income to determine how much of a taxpayer's Social Security is taxed. See: [https://www.irs.gov/publications/p915 Publication 915, Social Security and Equivalent Railroad Retirement Benefits]


==Risks==
==Risks==


===Call risk===
===Call risk===
Many bonds are issued with provisions which allow the issuer to repay the bond before the bond reaches maturity. This is termed "calling" the bond. Since issuers call bonds when interest rates fall and the the cost of financing the debt is cheaper in the new lower rate environment, a called bond is disadvantageous to the investor, who now must reinvest the returned capital at lower interest rates. An additional risk with a bond with a call feature is the tendency of the bond to have shifting durations as the likelihood of a call rises and falls with the fluctuation of market interest rates. The bond will sometimes be priced to the call date (when interest rates are falling); at other times to the maturity date (when interest rates are rising).<ref>This tendency is known as negative convexity. See [[Bonds: Advanced Topics#Convexity|Bonds:Advanced Topics]]</ref> Bonds with a call feature usually pay a higher interest rate than non-callable bonds as partial compensation for the increased risk.
Many bonds are issued with provisions which allow the issuer to repay the bond before the bond reaches maturity. This is termed "calling" the bond. Since issuers call bonds when interest rates fall and the the cost of financing the debt is cheaper in the new lower rate environment, a called bond is disadvantageous to the investor, who now must reinvest the returned capital at lower interest rates. An additional risk with a bond with a call feature is the tendency of the bond to have shifting durations as the likelihood of a call rises and falls with the fluctuation of market interest rates. The bond will sometimes be priced to the call date (when interest rates are falling); at other times to the maturity date (when interest rates are rising).<ref>This tendency is known as negative convexity. See [[Bonds: advanced topics#Convexity|Bonds:advanced topics]]</ref> Bonds with a call feature usually pay a higher interest rate than non-callable bonds as partial compensation for the increased risk.


===Credit risk===
===Credit risk===


Credit risk is generally much less than that for corporate bonds.  Nonetheless, it exists.(Refer to [http://www.moodys.com/cust/content/content.ashx?source=StaticContent/Free+pages/Credit+Policy+Research/documents/current/2001700000407258.pdf Moody’s US Municipal Bond Rating Scale] for data on defaults). Some municipal bonds are insured by private insurance companies. ([http://www.afgi.org/who-fact.htm AFGI - The Basics]}
Credit risk is generally much less than that for corporate bonds.  Nonetheless, it exists.(Refer to [http://www.moodys.com/cust/content/content.ashx?source=StaticContent/Free+pages/Credit+Policy+Research/documents/current/2001700000407258.pdf Moody’s US Municipal Bond Rating Scale] for data on defaults). While only 5 corporations have a AAA credit rating, 16 states are rated AAA.  Furthermore over 90% of municipal bonds are rated A or better by Fitch, while the average corporate bond is rated in the B range<ref>[http://www.learnbonds.com/municipal-bond-defaults/ Municipal Bond Defaults: Don’t Believe the Hype], LearnBonds</ref>.  The default rates reflect those higher ratings.  According to a report by Moody’s<ref>[http://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_140114 Moody's], registration required.</ref> which covers the default rates of municipal bonds from 1970 to 2011, the average default rate of rated municipal bonds was .13% during that time.  That compares to an average default rate of 11.17% for rated corporate bonds over that same time period. 
 
Some municipal bonds are insured by private insurance companies. ([http://www.afgi.org/who-fact.htm AFGI - The Basics]}


Some investors seek to  mitigate the credit risk by diversifying their municipal bonds beyond the state of residence.  The caveat is that they may have to pay state income tax on the interest from out-of-state municipal bonds.
Some investors seek to  mitigate the credit risk by diversifying their municipal bonds beyond the state of residence.  The caveat is that they may have to pay state income tax on the interest from out-of-state municipal bonds.
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Municipal bonds are generally illiquid,<ref>A security that cannot easily be sold or exchanged for cash without a substantial loss in value. [http://www.investopedia.com/terms/i/illiquid.asp illiquid], from Investopedia</ref> especially at the retail level.  To mitigate the risk, you may consider holding them to maturity or holding them through a low-cost mutual fund, which can trade on the wholesale market.
Municipal bonds are generally illiquid,<ref>A security that cannot easily be sold or exchanged for cash without a substantial loss in value. [http://www.investopedia.com/terms/i/illiquid.asp illiquid], from Investopedia</ref> especially at the retail level.  To mitigate the risk, you may consider holding them to maturity or holding them through a low-cost mutual fund, which can trade on the wholesale market.
==Meredith Whitney==
In 2010 analyst Meredith Whitney was interviewed on 60 Minutes and predicted that there would be 50 to 100 sizable defaults<ref>http://youtu.be/hI-rIGyLri4{{Dead link}}</ref>.  Whitney came to fame by being one of the first analysts to predict the banking crisis in 2008, so many investors took that statement to heart.  According to a Vanguard article on the topic<ref>https://personal.vanguard.com/us/insights/article/muni-non-crisis-112012{{Dead link}}</ref>, from November of 2010 to November of 2011 investors withdrew $35 Billion from municipal bond funds.  Unfortunately for those investors her prediction did not come true this time and the municipal bond market rallied over 12% during that time.


==Role in a portfolio==
==Role in a portfolio==


* If you have filled up your tax-advantaged accounts with tax-inefficient assets (taxable bonds, [[Real Estate Investment Trust | REITs]], [[Commodities | commodities]], etc), and you still need bonds to meet your desired stock/bond asset allocation, you might consider placing municipal bonds (or a mutual fund thereof) in your taxable account.
* If you have filled up your tax-advantaged accounts with tax-inefficient assets (taxable bonds, [[Real estate investment trust | REITs]], [[Commodities | commodities]], etc), and you still need bonds to meet your desired stock/bond asset allocation, you might consider placing municipal bonds (or a mutual fund thereof) in your taxable account.
* If you are in high tax brackets, and you are saving for short-term cash needs (such as car, home down payment, etc), then you might consider short-term municipal bonds or tax-exempt money market funds.  (Note that [https://personal.vanguard.com/ Vanguard]'s tax-exempt money market funds contain AMT bonds.  [https://www.fidelity.com/homeframe_cp.shtml Fidelity] offers some AMT-free tax-exempt money market funds as well as those with AMT bonds in them.)
* If you are in high tax brackets, and you are saving for short-term cash needs (such as car, home down payment, etc), then you might consider short-term municipal bonds or tax-exempt money market funds.  (Note that [https://personal.vanguard.com/ Vanguard]'s tax-exempt money market funds contain AMT bonds.  [https://www.fidelity.com/homeframe_cp.shtml Fidelity] offers some AMT-free tax-exempt money market funds as well as those with AMT bonds in them.)


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Taxable equivalent yield of a municipal bond is one that a taxable bond would have to pay to deliver the same amount of income as the municipal bond.  The taxable equivalent yield depends on the investor's tax brackets.  The following calculators allow you to calculate the taxable equivalent yield.
Taxable equivalent yield of a municipal bond is one that a taxable bond would have to pay to deliver the same amount of income as the municipal bond.  The taxable equivalent yield depends on the investor's tax brackets.  The following calculators allow you to calculate the taxable equivalent yield.


*[https://personal.vanguard.com/us/FundsTaxEquivForYield Vanguard Taxable-Equivalent Yield Calculator]
*[http://files.thefinancebuff.com/calculators/Bond-Funds-Yield-Calculator.html Boglehead tfb's Bond Fund Yield Calculator]
*[http://files.thefinancebuff.com/calculators/Bond-Funds-Yield-Calculator.html Boglehead tfb's Bond Fund Yield Calculator]
*[http://screen.morningstar.com/BondCalc/BondCalculator_TaxEquivalent.html Bond Calculator]
*[http://screen.morningstar.com/BondCalc/BondCalculator_TaxEquivalent.html Bond Calculator] (login required)


It's important to calculate the taxable equivalent yield before purchasing municipal bonds because taxable bonds with comparable credit ratings may have greater yields.
It's important to calculate the taxable equivalent yield before purchasing municipal bonds because taxable bonds with comparable credit ratings may have greater yields.
==Notes==
<references group="note" />
==See also==
*[[Municipal bond fund regulation]]


==References==
==References==
<references />
{{Reflist|30em}}
 
===Further reading===
* [[Larry Swedroe | Larry E. Swedroe]], Joseph H. Hempen (2005). [http://www.amazon.com/Only-Guide-Winning-Strategy-Youll/dp/0312353634?tag=bogleheadswiki-20 The Only Guide to a Winning Bond Strategy You'll Ever Need].
* The [http://www.msrb.org/EducationCenter.aspx MSRB Education Center] (Municipal Securities Rulemaking Board) provides comprehensive tutorials to help individual investors, as well as state and local governments, understand the municipal securities market.
** [http://www.msrb.org/glossary.aspx Glossary of Municipal Securities Terms]
** [http://www.msrb.org/EducationCenter/library/videos.aspx Video Library]
** [http://www.msrb.org/EducationCenter/library/pdfs.aspx Fact Sheets]


==External links==
==External links==
*[http://emma.msrb.org/ EMMA Electronic Municipal Market Access]
*{{Forum post|t=255686 | title= How are muni rates determined?|date=Aug 04, 2018 |author=leftcoaster}}
*[http://www.investinginbonds.com/learnmore.asp?catid=8 About Municipal Bonds]
*[http://www.msrb.org/About-MSRB.aspx Municipal Securities Rulemaking Board], overview.
*[http://www.vanguard.com/pdf/flgmb.pdf?22100219 Municipal Bond Funds and Individual Bonds] Vanguard Investment Counseling & Research
*[http://emma.msrb.org/ EMMA Electronic Municipal Market Access], Municipal Securities Rulemaking Board.
*[http://www.investinginbonds.com/learnmore.asp?catid=8 About Municipal Bonds], Project Invested.
*[http://www.vanguard.com/pdf/icrmb.pdf Municipal Bond Funds and Individual Bonds] Vanguard Investment Counseling & Research
*[http://www.bogleheads.org/forum/viewtopic.php?f=1&t=87083 zero coupon bonds], forum discussion. Guidance on long duration individual municipal bonds. Includes a trading activity example from [http://emma.msrb.org/ EMMA Electronic Municipal Market Access] - see [http://www.bogleheads.org/forum/viewtopic.php?p=1249741#p1249741 this post].
*[http://www.bogleheads.org/forum/viewtopic.php?f=1&t=87083 zero coupon bonds], forum discussion. Guidance on long duration individual municipal bonds. Includes a trading activity example from [http://emma.msrb.org/ EMMA Electronic Municipal Market Access] - see [http://www.bogleheads.org/forum/viewtopic.php?p=1249741#p1249741 this post].


===Further Reading===
==Affiliate links==
 
{{Affiliate links}}
* [[Larry Swedroe | Larry E. Swedroe]], Joseph H. Hempen (2005). [http://www.amazon.com/Only-Guide-Winning-Strategy-Youll/dp/0312353634?tag=bogleheadswiki-20 The Only Guide to a Winning Bond Strategy You'll Ever Need].
 


===Academic Papers===
===Bibliography===
{| class="navbox" style = width:100%;float:right;margin-left:1em;margin-right:0em;
{| border="0"
|-
||  
! style="border: solid #BEBEBE; border-width: 1px 0" colspan=2|Academic Papers
* Downing, Chris T. and Zhang, Frank Xiaoling, ''[http://ssrn.com/abstract=333620 Trading Activity and Price Volatility in the Municipal Bond Market]'', FEDS Working Paper No. 2002-39. Available at SSRN.  
|-bgcolor="Azure"
* Harris, Lawrence  and Piwowar, Michael S., [http://ssrn.com/abstract=503062 Municipal Bond Liquidity]'', (February 13, 2004). AFA 2005 Philadelphia Meetings. Available at SSRN.  
|align="left"|
* Singh, Rajdeep and Nanda, Vikram  K., ''[http://ssrn.com/abstract=171412 Bond Insurance: What is Special about Munis?]'', Available at SSRN.  
[[Image:Scholar.jpeg| link=Category:Academics | Academics|50px]]
* Wu, Chunchi, Wang, Junbo and Zhang, Frank Xiaoling, ''[http://ssrn.com/abstract=687500 Liquidity, Default, Taxes and Yields on Municipal Bonds]'', (March 14, 2006). FEDS Working Paper No. 2005-35. Available at SSRN.  
|align="left"|
*Bennyhoff, Donald G., [https://personal.vanguard.com/pdf/flgmb.pdf Municipal Bond Funds and Individual Bonds], Vanguard Investment Counseling & Research
*Downing, Chris T. and Zhang, Frank Xiaoling, "Trading Activity and Price Volatility in the Municipal Bond Market". FEDS Working Paper No. 2002-39. Available at SSRN: http://ssrn.com/abstract=333620
*Harris, Lawrence  and Piwowar, Michael S., "Municipal Bond Liquidity"(February 13, 2004). AFA 2005 Philadelphia Meetings. Available at SSRN: http://ssrn.com/abstract=503062
*Singh, Rajdeep and Nanda, Vikram  K.,Bond Insurance: "What is Special about Munis?". Available at SSRN: http://ssrn.com/abstract=171412 or DOI:  10.2139/ssrn.10.2139/ssrn.171412
*Wu, Chunchi, Wang, Junbo and Zhang, Frank Xiaoling, "Liquidity, Default, Taxes and Yields on Municipal Bonds"(March 14, 2006). FEDS Working Paper No. 2005-35. Available at SSRN: http://ssrn.com/abstract=687500
|}
|}


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Revision as of 18:24, 1 March 2020

Municipal bonds are bonds issued by states and local governments.

Types of municipal bonds

  • General Obligation Bonds are municipal bonds secured by the taxing and borrowing power of the municipality issuing it.[1]
  • Revenue Bonds are municipal bonds supported by the revenue from a specific project, such as a toll bridge, highway, or local stadium.[2]
  • Assessment Bonds are special types of municipal bonds used to fund a development project. Interest owed to lenders is paid by taxes levied on the community benefiting from the particular bond-funded project.[3]
  • Build America Bonds are municipal bonds issued under a program begun in 2008. Through the BAB program, the Federal government directly subsidizes taxable municipal bonds instead of subsidizing municipal bonds via a tax break for their purchasers. This opens the market up to a wider range of participants, including tax-exempt institutions and individuals with sufficient tax-exempt space.

Taxation

Interest

Interest from municipal bonds is generally exempt from federal income tax and the issuing state's income tax.[note 1] However, there are a few exceptions.

  • Interest from some municipal bonds is subject to Alternative Minimum Tax (AMT) although whether you actually have to pay AMT depends on your individual circumstances. Such bonds are commonly referred to as AMT bonds.
  • Some states charge income tax on interest from their own municipal bonds.

Areas of note:

  • Puerto Rico, Guam, and US Virgin Islands: No state can tax bond interest issued by US territories.[4]
  • New York City: Bonds issued in NY may be triple tax-exempt from city, state, and federal income taxes.[4]
  • Utah: Utah reciprocates taxation. Utah does not tax its own bonds, but also does not tax bonds issued in states that do not tax Utah bonds.[4]
  • Washington D.C.: Does not tax in-state or out-of-state municipal bonds.[4]

Capital gains/losses

Capital gains and losses are subject to taxation. One notable point is the treatment of capital losses for a holding period of less than six months. For an ETF holding bonds (but not for a traditional mutual fund if the fund accrues dividends daily and pays them at least monthly, as most bond funds do), if you received exempt-interest dividends, at least part of your loss is disallowed. You can deduct only the amount of loss that is more than the exempt-interest dividends. Report the loss as a short-term capital loss. See Publication 550 (2012), Investment Income and Expenses and Short-Term Capital Losses for more details.

Social Security

Municipal bond interest is included in modified adjusted gross income to determine how much of a taxpayer's Social Security is taxed. See: Publication 915, Social Security and Equivalent Railroad Retirement Benefits

Risks

Call risk

Many bonds are issued with provisions which allow the issuer to repay the bond before the bond reaches maturity. This is termed "calling" the bond. Since issuers call bonds when interest rates fall and the the cost of financing the debt is cheaper in the new lower rate environment, a called bond is disadvantageous to the investor, who now must reinvest the returned capital at lower interest rates. An additional risk with a bond with a call feature is the tendency of the bond to have shifting durations as the likelihood of a call rises and falls with the fluctuation of market interest rates. The bond will sometimes be priced to the call date (when interest rates are falling); at other times to the maturity date (when interest rates are rising).[5] Bonds with a call feature usually pay a higher interest rate than non-callable bonds as partial compensation for the increased risk.

Credit risk

Credit risk is generally much less than that for corporate bonds. Nonetheless, it exists.(Refer to Moody’s US Municipal Bond Rating Scale for data on defaults). While only 5 corporations have a AAA credit rating, 16 states are rated AAA. Furthermore over 90% of municipal bonds are rated A or better by Fitch, while the average corporate bond is rated in the B range[6]. The default rates reflect those higher ratings. According to a report by Moody’s[7] which covers the default rates of municipal bonds from 1970 to 2011, the average default rate of rated municipal bonds was .13% during that time. That compares to an average default rate of 11.17% for rated corporate bonds over that same time period.

Some municipal bonds are insured by private insurance companies. (AFGI - The Basics}

Some investors seek to mitigate the credit risk by diversifying their municipal bonds beyond the state of residence. The caveat is that they may have to pay state income tax on the interest from out-of-state municipal bonds.

Liquidity risk

Municipal bonds are generally illiquid,[8] especially at the retail level. To mitigate the risk, you may consider holding them to maturity or holding them through a low-cost mutual fund, which can trade on the wholesale market.

Meredith Whitney

In 2010 analyst Meredith Whitney was interviewed on 60 Minutes and predicted that there would be 50 to 100 sizable defaults[9]. Whitney came to fame by being one of the first analysts to predict the banking crisis in 2008, so many investors took that statement to heart. According to a Vanguard article on the topic[10], from November of 2010 to November of 2011 investors withdrew $35 Billion from municipal bond funds. Unfortunately for those investors her prediction did not come true this time and the municipal bond market rallied over 12% during that time.

Role in a portfolio

  • If you have filled up your tax-advantaged accounts with tax-inefficient assets (taxable bonds, REITs, commodities, etc), and you still need bonds to meet your desired stock/bond asset allocation, you might consider placing municipal bonds (or a mutual fund thereof) in your taxable account.
  • If you are in high tax brackets, and you are saving for short-term cash needs (such as car, home down payment, etc), then you might consider short-term municipal bonds or tax-exempt money market funds. (Note that Vanguard's tax-exempt money market funds contain AMT bonds. Fidelity offers some AMT-free tax-exempt money market funds as well as those with AMT bonds in them.)

Taxable equivalent yield

Taxable equivalent yield of a municipal bond is one that a taxable bond would have to pay to deliver the same amount of income as the municipal bond. The taxable equivalent yield depends on the investor's tax brackets. The following calculators allow you to calculate the taxable equivalent yield.

It's important to calculate the taxable equivalent yield before purchasing municipal bonds because taxable bonds with comparable credit ratings may have greater yields.

Notes

  1. States with no income tax do not impose taxes on municipal bonds.

See also

References

Further reading

External links

Affiliate links

Bogleheads.org is an Amazon Associate and may earn from qualifying purchases made through Amazon.com.

Bibliography