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What Are the Advantages to Tax-Free Municipal Bonds?

Thursday, Sep 18, 2014

Tax-free municipal bonds can be an attractive investment for individuals seeking a steady source of tax-free fixed income, particularly for ”High Net Worth” individuals. Their typical combination of relatively high safety of investment, predictability of income, and tax exemption make them a popular choice for the fixed-income component of an investment portfolio.

Let’s look at the advantages alittle.

Tax-Free Interest Income

While the interest income on tax-free municipal bonds is exempt from federal taxes by definition, it may also be free of state and local taxes – providing a rare triple-tax-free investment. Generally, bonds issued in any particular state are exempt from that state’s taxes.

Rules vary by state, but typically buying bonds issued within your state or municipality removes that particular tax burden, while bonds issued by out-of-state entities are still subject to local taxes. Check the rules for your state before making any municipal bond purchases.

However, this doesn’t mean that you should only buy municipal bonds that are issued in your area. Federal taxes make up the majority of the tax burden, and you may find an out-of-state issue with an attractive enough yield to compensate for the local taxes.

Safe and Predictable Income Stream

Municipal bonds generally provide high levels of safety, fixed semiannual interest payments, on and repayment of principal on a selected maturity date. Defaults are rare, and bond ratings are usuallyin the investment-grade range.

The 2012 report U.S. Municipal Bond Defaults and Recoveries, 1970-2011 from Moody’s Investors Service states that at the end of 2011 almost all of the rated municipal bond issuers had investment grade ratings. 94% of the municipal issuers rated single-A or higher.

General obligation (GO) bonds have the additional benefit of being backed by the issuing entity. The issuer has theability to alter tax rates to increase revenue if necessary to satisfy obligations to the bondholders, thus GO bonds offer an inherent high level of security.

Revenue bonds in turn are secured by the revenues generated from the facility or project built with the funds collected from the bond issue. Transportation and infrastructure projects such as toll bridges or roads, airports, and utility plants are typical examples. While the levels of revenue from these projects are not guaranteed, essential service revenue bonds have an overall excellent track record of meeting bondholder obligations.

A Wealth of Choices

The overall municipal bond market is approaching the $4 trillion mark, with thousands of issuers and a variety of terms, yields, and associated risk levels. Whether you are looking for an extremely safe investment with the highest bond rating available or considering more aggressivebonds to achieve higher yields, there is a high probability that an available municipal issue will fit your needs.

While municipal bonds are generally safe, they are not entirely free of risk. As with any investment, you should take the time to understand the risks associated with any specific issue, and consider whether the yield on the bond is appropriate for the relative risk that you assume.

If you are looking for an attractive tax advantaged fixed income investment to complement your portfolio holdings, consider purchasing tax-free municipal bonds. With the wide variety of municipal issues available, you are likely to find a bond that meets your specific investment requirements and provides you with safe and predictable tax-free income.