Municipal Versus Taxable – Which Bond Is Better?

I often receive this question from people at a cocktail party, or on the golf course.

“So my broker pitched me a 5%, 15 year municipal bond in Indiana. Is that a good investment?”

As with most things in finance, there is no right or wrong answer to this question.

From a tax planning perspective, there are advantages to both municipal bonds, and taxable bonds.

However, if you are simply comparing a taxable bond to a muni bond from an investment perspective, there are three criteria to be aware of.

Tax-Exempt Interest

By far, the largest advantage, and most important criteria to evaluate, is the tax-exempt feature of municipal bonds.

Unlike traditional corporate bonds, the interest you receive from a municipal bond is federal tax-exempt (with the exception of certain “private activity bonds”, which may be subject to the AMT)

“So wait, you’re telling me that I don’t pay interest on muni-bonds, but I do pay taxes on corporate bonds. Why would I ever buy a corporate bond?”

The reason is that the interest paid on municipal bonds is usually lower than that paid by corporate bonds.

This was a tax-break initially created by the federal government, to make it easier and cheaper for municipalities to borrow money.

So how do we compare a tax-exempt bond with a lower interest rate, to a taxable bond with a higher interest rate?

Fortunately, the world of finance has created a very simple solution, which is to calculate the “tax-equivalent yield” of a municipal bond and compare that to the interest rate on a taxable bond.

Tax-Equivalent Yield = Tax-Exempt Interest Rate / (1 – Your Federal Income Tax Rate)

All else being equal, if the tax-equivalent yield of a municipal bond is greater than the interest rate of a taxable bond, the municipal bond is a better investment.

So, using the formula above let’s look at a real world example:

You are comparing two bonds, one corporate and one muni.

The taxable bond is paying 8%, and the muni-bond is paying 6%. You are in the 35% tax bracket.

Which is better?

Well, let’s look at the formula.

Tax Equivalent Yield = 6% / (1 – 0.35)

= 9.23%

Because the 9.23% is higher than the corporate interest rate of 8%, the muni-bond is a better option.

Let’s make a quick change to that scenario: Let’s assume that your federal income tax rate is 15%, not 35%.

Tax Equivalent Yield = 6% / (1 – 0.15)

= 7.06%

In this case, the muni-bond is NOT the best option.

As the previous example illustrates, municipal bonds are more attractive to those in higher income tax brackets. This is because they have the potential for greater tax savings than someone in a lower tax bracket.

A Couple Of Points

1. While municipal bonds are exempt from federal income tax, they are not always exempt from local income taxes.
   
   Typically, in you must live in the state that issued the municipal bond for the interest to be free from local income taxes.
2. Any bond issued by a U.S. Territory is triple-tax-free.

   The most typical scenario involves bonds issued by Puerto Rico.

   If you buy a Puerto Rican bond, you will not pay federal, state or local taxes on the interest received.

Credit Analysis

There are two primary types of municipal bonds: General Obligation (GO) bonds, and Revenue bonds.

GO bonds are paid for by the tax collections of the municipality (primarily property taxes).

Revenue bonds are paid for by the revenue generated through whatever project that bond funded.

Because GO bonds are backed by the full faith and credit of the municipality that issued them, they have historically been viewed as very secure with very little risk. However, in our current economic situation, it is fair to say that GO bonds are much less secure than they have historically been (think California).

Revenue bonds, on the other hand, are backed by a specific project.

For example, if a municipality issues a revenue bond to build a new turnpike, and charges a toll for using that road, the revenues from the toll collections are what is used to pay the interest on the bond.

Revenue bonds are not backed by the municipality that issued them, they are only backed by the revenue generated through the project which they funded. This increases the risks associated with these bonds, and as such, they typically pay a slightly higher interest rate.

Taxable Municipal Bonds

Popularized by President Obama’s recent push for Build America Bonds, municipal bonds have become more prevalent in today’s world.

While still only a fraction of the overall municipal bond market, it is important to mention them.

Taxable municipal bonds are, as their name implies, municipal bonds that pay out taxable interest.

Why would they do that?

To make the bonds more attractive to a wider array of investors.

As we discussed above, the tax-exempt interest feature of a muni-bond is most attractive to those in higher federal income tax brackets.

For those who are in a lower tax bracket, a taxable muni bond gives them the ability to obtain a higher yield, while also benefiting from the creditworthiness of a municipal issuer.

It is important to be aware of whether or not the municipal bond you are purchasing is in fact taxable, or tax-exempt.

As I mentioned at the beginning of this article, this discussion revolves only around the investment merits of a taxable versus municipal bond.

From a planning perspective, would you purchase a municipal bond in an IRA, even if its tax-equivalent yield was higher?

No, you would not.

Why? Because interest is not taxed in your IRA anyway, so you don’t receive any of the tax benefits as you would in a taxable account.

That is just one example, and one reason why it is important to conduct a thorough analysis of your consolidated accounts, and the assets you hold in them, prior to making any decisions about how to best allocate your assets.

However, you can now feel confident that the next time someone brings up their GO muni bond at a party, you can kick-back with why you analyzed the GO bond, but decided that a revenue bond with higher interest was a better investment.