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Key Points Consider Your Tax SituationThe Tax Efficiency of Managed Municipal Bond InvestmentsPortfolio Management StrategiesPoints to Remember
Municipal bonds have long been considered a haven
for high-net-worth investors because their income returns are generally free
from federal income taxes and, in some cases, state and local income taxes.
In choosing whether and how to invest in municipal issues, you will want to
consider your tax situation, the after-tax returns of municipal bonds compared
to taxable issues, and the tax-efficiency of managed municipal bond investments. | Top |
The reduction in the maximum capital gains tax rate
in 1997 and again in 2003 made municipal bonds less attractive to many long-term
investors. The maximum tax on long-term capital gains now stands at 15%, well
below the current top income tax rate of 35%. However, if you are investing
for income, or are seeking income investments to diversify a stock portfolio,
you’ll want to compare the after-tax returns of municipal bonds and taxable
issues. Municipal bonds’ pretax yields historically have averaged approximately
32% below those available on Baa-rated corporate and 15% below government issues of the same maturities, making them an
attractive investment for investors in the 25% tax bracket or above.1
Your financial advisor can assist you in comparing
the after-tax yield on tax-exempt municipals to that of taxable issues. The
accompanying table shows the taxable-equivalent yield for different yields and
federal income tax brackets. These figures provide a general reference, but
may not be applicable to your situation. While income from corporate bonds is
generally fully taxable, income from U.S. government bonds is exempt from state
income taxes. If you are in a high-tax state or locality that also exempts interest
income from locally issued municipal bonds (known as double or triple tax-exempt
bonds), the calculation of taxable-equivalent yield for those issues must be
adjusted to reflect the state and local income tax savings. Other tax considerations you should be aware of before
investing in municipal bonds include:
- Capital gains on municipal bond investments are taxable
as short-or long-term capital gains, depending on how long you have held the
investment.
- Income from certain bonds, known as private-activity
bonds, must be reported as taxable income if you are subject to the alternative
minimum tax. These bonds, which are used to finance projects such as sports
stadiums or airport terminals that provide some benefits to private companies,
are identified as private-activity bonds in their prospectuses.
- Municipal bonds generally are not held in tax-deferred
retirement accounts since the investment returns in these accounts are taxed
as ordinary income upon withdrawal.
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Individuals may invest directly in individual bonds,
in municipal bond mutual funds, or through a privately managed account. Managed
investments offer the advantages of professional management and, in the case
of mutual funds, greater diversification. However, actively managed mutual funds
may generate taxable short- and long-term capital gains, offsetting some of
the potential tax advantages of municipal bond investing.
According to Morningstar, 100% of municipal bond funds that have at least a five-year track record had tax-efficiency
ratings of 95% or better as of December 31, 2008, with the average tax-efficiency being 99%.2 In selecting a mutual fund investment, investors
will want to consider the impact of capital gains taxes on the potentially higher
pretax return that a fund’s investment management policies may provide. Some funds may have accrued capital losses in previous
years that can be carried forward and applied against future capital gains. A privately managed account combines the benefits
of professional management and direct ownership of the underlying securities.
One advantage of investing in municipal bonds through a privately managed account
is the potential tax savings that can result from coordinating the recognition
of losses in the bond portfolio to offset taxable gains on other investments
that you may have. If you have large, unrealized gains in stock positions,
for example, short-term losses on your municipal bond investments may offer
opportunities to realize some of the gains on your stock holdings. Using a technique
known as "tax loss harvesting," a private account manager may sell some bonds
when prices are depressed, resulting in realized capital losses. The proceeds
of the sale are then reinvested in different bond issues, and the losses may
be used to offset realized gains on an equal amount of appreciated stock. Because
longer-term bonds tend to be more volatile than shorter-term issues, an investor
using this strategy may prefer a portfolio that includes long-term bond issues.
| Taxable vs. Tax-Free Yield |
| Tax Bracket |
10% |
15% |
25% |
28% |
33% |
35% |
|
| Tax Exempt Yield |
Taxable-equivalent yields |
| 2% |
2.2% |
2.4% |
2.74% |
2.8% |
3.0% |
3.1% |
| 3% |
3.3% |
3.5% |
4.0% |
4.2% |
4.5% |
4.6% |
| 4% |
4.4% |
4.7% |
5.3% |
5.6% |
6.0% |
6.2% |
| 5% |
5.6% |
5.9% |
6.7% |
6.9% |
7.5% |
7.7% |
| 6% |
6.7% |
7.1% |
8.0% |
8.3% |
9.0% |
9.2% |
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Municipal bond prices are sensitive to changes in
interest rates and to demand and supply factors. The low-interest-rate climate of the past few years made borrowing especially attractive, both for new projects and for refinancing older debt. An estimated $2.4 trillion in municipal bonds was outstanding at the end of 2006, representing nearly 9% of all outstanding fixed-income securities.3 Municipal bond yields were 84% of comparable maturity Treasury yields as of the end of 2006, in line with the 86% difference over the past 50 years. 4
Bond investors are generally hurt by higher interest
rates, as bond prices fall when interest rates rise, and benefit when interest
rates fall. However, most long-term municipal bonds are callable by the issuer
prior to their maturity date at face value. An issuer is likely to call bonds
that carry interest rates above the current market rate. The bond’s call provisions
will specify the earliest date that the bond may be called, which may be as
soon as 10 years after the issue date. If you purchase individual bonds for
more than their face value, it’s important to consider whether the bond offers
an attractive yield to the call date, rather than maturity. Like other types of bonds, municipal bonds carry
credit risks. For example, a slowing economy generally creates wider price spreads between high-
and medium-quality municipal bonds, offering professional managers opportunities
to potentially add incremental returns through careful security selection. High-yield
and variable-rate municipal issues offer higher yields than general obligation
or revenue bonds but also pose greater risk of default. Combining investments
from several states and investing in insured bonds are two strategies that can
help reduce the credit risk of a municipal bond portfolio.
| Value of $1,000 Bond Investment: 1979-2008 |
 |
| Source: Standard & Poor’s. Illustration
based on total yields of municipal bonds as represented by The Bond Buyer
muni composite, with 20-year average maturity, for the period December 31,
1978, to December 31, 2008. Individuals cannot invest directly in any index.
Past performance is not indicative of future returns. (CS000147) |
1Source: Federal Reserve. Based on 20-year yields, yields of Baa-rated corporate bonds and General Obligation municipal yields over the 50-year period ended December 31, 2008. 2Source: Standard & Poor’s. Based on all funds tracked by Standard & Poor’s as of December 31, 2008, classified as domestic tax-exempt bond funds with a history of at least five years. 3Source: The Bond Market Association, December 31, 2008. 4Source: Federal Reserve, December 31, 2008.
- Interest income from municipal bonds is usually exempt from federal income taxes and in some cases state and local income taxes. Capital gains are taxed as short- or long-term capital gains. Income from private-activity bonds is reported as taxable income if you are subject to the alternative minimum tax.
- The taxable-equivalent yield compares the yield on tax-exempt bonds to yields on taxable corporate or government bonds. The calculation of the taxable-equivalent yield is adjusted if you are comparing a municipal bond to a government bond — which is free of state income taxes — or for a locally issued municipal bond that is exempt from state taxes ("double tax exempt") or state and local taxes ("triple tax exempt").
- If you are investing in an actively managed municipal bond mutual fund, consider how taxes on short- and long-term capital gain distributions may affect your after-tax return.
- Privately managed accounts offer opportunities to coordinate the recognition of losses on a bond portfolio to offset gains elsewhere in your portfolio.
- Many municipal bonds are callable by the issuer prior to maturity. If you purchase a bond for more than face value that offers an above-market yield and the bond is called, you may lose some of the premium paid.
- Municipal bonds carry credit risks in addition to interest rate risk. The credit exposure of a bond portfolio may be reduced by diversifying among bonds issued by different states and by investing in insured bonds.
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