Municipal Bonds

There is a very famous movie about municipal bonds. The movie is Chinatown.

Set in 1938 and starring Jack Nicholson, Faye Dunaway, and John Huston it is a psychological thriller and murder mystery about the Los Angeles Department of Water and Power. How did Los Angeles get its water?

In the municipal bond world, the acronym for the Los Angeles Department of Water and Power bonds LADWP’s (pronounced dee-wop). LADWP is the largest municipal utility in the United States.

Utility bonds are not typically involved in murder.

Municipal Bonds are curious creatures indeed.

And like many bonds they have unique characteristics.

“Muni’s” are best  known for the tax exemptions on the income from the bond. The income from muni’s is federally tax free. The income might also be tax free at the state and local levels.

Tax free income! Don’t we all want it? There has to be a catch.

You know a lot about ”muni’s.” Building new bridges, expanding hospitals, repairing schools, improving your water systems are paid for by issuing municipal bonds.

Issuing a municipal bond means a state, city or local government is borrowing money to pay for projects.

Voters approve Projects. If voter approval is needed for a new water and sewer treatment plant, it means the city or state is asking you if you are willing to pay higher taxes to “approve” the project.

In other words, you the taxpayer pay off municipal debt.

Most people don’t realize that voting for infrastructure projects, like highways and hospitals gives your state or local government the authority to raise your taxes to pay off the borrowing i.e. the municipal bond.

The ability of a state or city to borrow money through the issuance of a municipal bond tells another story.

Municipal bonds tell you about quality of life. If one city is issuing a bond to repair playgrounds, versus a city that issues bonds for water and sewer treatment plants, the playground people are willing to pay higher taxes to have playgrounds repaired. Seriously.

From the perspective of someone who trades municipal bonds, there are no apples to apples comparisons.

Here is an example:

• Both Maryland and  Georgia issue General Obligation bonds.
• Both states are rated Aaa by Moody’s and AAA by Standard and Poor’s.
• The Maryland GO trades at a slightly lower yield than the Georgia GO.

In bond language you would say the Georgia bond is cheaper (has a higher yield) than the Maryland bond even though both are General Obligation bonds and both are AAA rated.

There are a number of factors that influence the yield on a bond. But one of the weird things about muni’s is that traders develop a “sense” of how one issuer trades versus another. Many times, there is no “logical” reason and that is a big challenge for someone trying to understand this wiley coyote.

Muni’s are not for everybody.

Buying muni’s involves tax planning.

The investors who benefit the most are high net worth individuals in high tax brackets who want to lower the taxes they pay on income. Typically, it is retirees who invest in municipal bonds.

Muni’s used to be straight forward. If you were a resident of  New York City, and bought a New York City municipal bond, the income would be federally, state and locally tax free.

Triple tax free!

Today there are many different types of municipals, not all have tax free income.

Here is another catch. Municipal bonds pay lower interest rates than “taxable bonds.”

A taxable bond would be a corporate bond. You have to compare the taxable income to the tax free income.

When you compare the income from a corporate bond to a municipal bond there is a little calculation ( that you do not have to learn ) called the “taxable equivalent yield”

Here’s how it works:

You are in the highest tax bracket . Not a bad problem to have. Your federal and state tax bracket combined is 45%.

1. Use the reciprocal number of your tax bracket. In this example it is 55%
2. Divide 55% by the tax-exempt yield

We are looking at a municipal bond that pays 2.00%. 2.00% divided by 55% (2.0/.55) equals 3.63%.

If taxable bonds are paying more than 3.63% , you buy the taxable bond because after you pay taxes on the income your return will still be higher than the 2.00% the municipal bond is paying.

Here is a little history on municipal bonds:

Officially the first recorded municipal bond was a general obligation bond issued by the City of New York for a canal in 1812. During the 1840s, many U.S. cities were in debt, and by 1843 cities had roughly $25 million in outstanding debt. In the ensuing decades, rapid urban development demonstrated a correspondingly explosive growth in municipal debt. The debt was used to finance both urban improvements and a growing system of free public education. (Wikipedia)

The reason I decided to write an investment article about municipal bonds is for you to have a basic understanding.

Most individuals use municipal bond funds instead of buying individual bonds.

Using municipal bond funds adds another layer of complexity to this odd beast.

If you are talking to an advisor who suggests that you invest in municipal bonds, make sure you have a good accountant who understands your tax situation before you invest.

 

 

This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.