The primary benefit of municipal bonds compared with other bonds is that the interest earned is typically exempt from federal income taxes. In general, income from municipal bonds is also exempt from state income taxes if you live in the state where the bond is issued.

Calculating the equivalent return of municipal bonds

Municipal bonds will typically have lower returns than an equally risky corporate or government bond. However, the interest on corporate and government bonds are usually taxable, so the difference in expected returns between municipal and taxable bonds narrows. Investors are willing to earn less interest on municipal bonds because they won’t have to pay taxes on that interest.

The tax-equivalent yield is calculated using the following formula:

Tax-equivalent yield = Yield / (1 – tax rate)

So if the yield on a municipal bond is 3% and you are in the 25% tax bracket, then the tax-equivalent yield would be 4% (3% / (1 – 25%)).

While this formula can be used for back-of-the-envelope calculations, there are significant weaknesses with using this formula to compare municipal and taxable bonds (see this Bogleheads thread for an excellent discussion).

Municipal bond investing tips

If you are going to invest in municipal bonds, here are some tips:

Invest in a taxable account

If you’re going to invest in municipal bonds, you should invest in a taxable account. You don’t get the tax benefits of municipal bonds over taxable bonds in a retirement account, since you don’t pay any taxes on profits in Roth retirement accounts and withdrawals (contributions and profits) are taxed as ordinary income in traditional retirement accounts.

Diversify your municipal bond portfolio

You should generally not invest in individual municipal bonds, just like I recommend against investing in individual stocks. If that municipal bond defaults, you could experience significant losses on your investment. Invest in a portfolio of municipal bonds and diversify your risk across multiple municipal bonds. Even better…

Buy passively invested municipal index funds

Buying a municipal bond fund enables you to get hundreds to thousands of municipal bonds in a single purchase. Like with stocks or taxable bonds, you should try to keep costs low. Invest in passively-managed municipal bond index funds that have low fees and expense ratios.

This is an area where Vanguard shines over Fidelity. Vanguard offers many municipal bond index funds. Some index funds are general municipal bond index funds (such as VTEAX, ER 0.09%), so you will only get the federal income tax benefit. Other Vanguard municipal bond funds are state-specific, where state residents can be exempt from both federal and state taxes. Fidelity also offers municipal bond funds, but at higher expense ratios.

Your state’s municipal bonds will provide the greatest tax benefit

State tax laws vary, but in general, you are exempt from state income tax on bonds that are issued in the state where you live. So to maximize your tax benefit, you should invest in bonds that your own state issues.

Don’t invest only in your state’s municipal bonds

Of course, you shouldn’t put all your money in your state’s municipal bonds, because it puts an inordinate amount of risk on the economy of a single state. You should buy a mix of your state’s municipal bonds and a general municipal bond fund.

Don’t invest only in municipal bond funds

Even if it is tax-advantageous to do so, you shouldn’t allocate your entire bond portfolio to municipal bonds. Municipal bonds have unique risk factors compared to the rest of the bond market. Of course, you could put the taxable bond fund in a retirement account and your municipal bonds in a taxable account.

The problem with municipal bonds

The value of municipal bonds is dependent on what tax bracket you are in. For investors who are in the 10 or 15% tax bracket, the tax benefits of holding municipal bonds are relatively low. The tax benefits of holding municipal bonds are maximized for investors in the top federal income bracket who are also residents of the state where the municipal bond is being issued.

Municipal bond prices are driven by supply and demand, and investors in the top tax bracket are willing to pay the most

The price of municipal bonds, like every other investment, is driven by supply and demand. The bonds will be sold at the price where someone is willing to buy it. Investors in the highest tax bracket, because they will receive the greatest benefit from holding municipal bonds, will be willing to pay the most of the bonds, and accept the lowest before-tax return. Any other investor in the municipal bond will pay the same price as the high tax bracket investor, and receive the same before-tax return.

However, the high-tax bracket investor will get a better after-tax return than other investors. Assuming that the high-tax bracket investor gets the same after-tax return with municipal bonds and comparable-risk taxable bonds, then lower tax-rate investors will get an inferior after-tax return with municipal bonds compared to taxable bonds.

When do municipal bonds make sense?

For investors in the top tax bracket, it is reasonable to invest in municipal bonds, provided you follow the investing tips above. Investors in lower tax brackets will derive less benefit from investing in municipal bonds. Investors in very low tax brackets should invest in taxable bonds, as they derive very little tax benefit from the municipal bonds compared to wealthier investors. Investors in middle tax brackets can consider holding a small portion of their taxable bond portfolio in municipal bonds for diversification reasons (note that Vanguard’s Total Bond index fund has less than 1% municipal bonds).

Conclusion

I personally do not have any bonds in my taxable account, but if I were to hold bonds, I would actually hold a regular total bond fund even though its returns would be taxed. It keeps things simple, and I believe that only investors in the top tax bracket derive the full value of municipal bonds. For investors in lower tax brackets, municipal bond returns are potentially inferior to taxable bonds, even after taxes.

“Wall Street Physician,” a former Wall Street derivatives trader , is a physician who blogs at his self-titled site, the Wall Street Physician.

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