Are Municipal Bonds Currently A Good Investment?

The short answer is probably not. Certificates of deposit (CDs) are safer and have a major yield advantage, even after factoring in the tax benefits of municipal bonds.

There are two main reasons that investors like to buy municipal bonds: The income they produce is generally not taxable, and they are perceived to be super-safe investments. Let’s explore these reasons more closely to see if they are valid.

When rates are low, the tax advantage is not very large.

Nobody likes the idea of having to pay taxes, and most municipal bonds provide a way to receive income free from federal, state and local taxes. However, the tax advantage for municipal bonds is smaller than most people think. First of all, most tools for estimating the tax benefits of owning municipal bonds provide inaccurate results that overestimate the benefits.

They ignore the fact that there is a difference between your marginal tax rate and your effective tax rate. Let’s say your family files a joint return and will make $85,000 in 2013. Your marginal federal tax bracket for 2013 is 25 percent. However, you will not pay 25 percent on all of your income. Instead, you will pay a 10 percent rate on the first $17,850, then 15 percent on then next $54,650, and finally 25 percent on the last $12,500. It doesn’t take a math genius to figure out that your effective tax rate will be closer to 15 percent. However, most tools will use the marginal rate of your highest tax bracket rather than your effective tax rate. In the example, most benefits calculators will overestimate the tax benefit by 40 percent.

This is not to say that the tax benefit is not important, particularly if you live in a place like New York where both the city and state taxes can be avoided by buying the right municipal bonds. However, the absolute value of the benefit is not very high when interest rates are low.

Only two years ago, at the beginning of 2011, one could buy a twenty year AA-rated municipal bond with a yield of 5.25 percent. Now, the yield on such a bond is only around 3.75 percent, down about a third. Yields on shorter-duration municipal bonds are even lower.

Let’s say your effective tax rate including federal, state and local income taxes is 25 percent. If you buy a municipal bond that yields 6 percent, it would be the equivalent of a taxable yield of 8 percent. Put another way, you would be earning an extra 2 percent because of the tax benefits. However, 10-year AA-rated municipal bonds are not earning close to 6 percent right now. They are earning around 2 percent, which is the taxable equivalent of 2.5 percent. The benefit is only half a percent in terms of extra return. Not very much. In this case the idea of not paying taxes is more powerful than the actual benefit.

How are CDs and municipal bonds taxed differently? Click here.

Investment grade municipal bonds are very safe, but FDIC-insured CDs are safer.

When you get a CD from a U.S. bank, your money is federally insured up to $250,000. The federal government is basically guaranteeing that you will receive your full deposit and earned interest back. Municipal bonds do not carry this federal guarantee. While municipal bonds have a very low default rate, they do sometimes default. In 2012, four investment grade bond issues defaulted, out of the approximately 10,000 issues rated by Standard & Poor’s. While the number represented is less than 0.1 percent, defaults did occur. As CDs are safer than bonds, the logical move would be to buy CDs instead of municipal bonds if the CDs provided the same or a higher after-tax return.

Let’s Take A Look:

* Data from Municipal Market Advisors

** Bank names and more rates available at http://www.learnbonds.com/best-cd-rates/

As you can see, CD yields after factoring in the tax benefits for a middle class to wealthy family are much higher than municipal bonds. For a five-year maturity which offers the smallest yield difference, the yield advantage is still six-tenths of a percent.