It’s Hard to Go Wrong With Municipal Bonds
What if I told you that you could invest with 99.92% confidence that you would make money?
That’s been the success rate of municipal (muni) bonds over the past 51 years. In other words, fewer than 1 muni bond out of every 10,000 has defaulted since the Richard Nixon administration.
Municipal bonds are loans that investors make to governments or quasi-governmental organizations. Some bonds are what are known as general obligation bonds, in which case the money is used by the city or county for general purposes. They are considered incredibly safe because of the taxing power of the issuer. Essentially, if the city or county couldn’t pay the bond, theoretically, it could levy taxes to do so.
Other muni bonds fund specific projects, such as a hospital, school or toll road. Often, the interest on those individual projects is paid by the revenue generated by the project. But they are typically less risky than they sound, thanks to the backing of the city or county where they are located.
Because muni bonds are so safe, they normally pay lower rates of interest. However, the interest is usually free from federal and state taxes, so your after-tax return is often similar to that of a taxable bond.
For example, if you own a corporate bond with a 3% yield and are in the 32% tax bracket, after paying federal taxes, you will wind up with 2.04%. If you live where there are state income taxes, your rate will be lower still.
If instead you buy a muni bond with a 2.25% yield, you won’t pay any tax on that 2.25% and will make more money after taxes than you would with a corporate bond.
Now, keep in mind, that’s on the interest only. The price of the bonds will affect your total return.
Muni bonds, like other bonds, trade at a discount or premium to par value ($1,000), so if you pay more or less than par, it will change your total return.
With today’s incredibly low interest rates, it’s tough to find decent muni bonds that pay a generous yield to maturity (the total return of the bond based on interest and price appreciation/depreciation at maturity).
But they do exist.
The bond with the highest yield to maturity with a maximum maturity of December 2026 that I found is the Cook County, Illinois, Community College District 508 (CUSIP 213187ca3) bonds with a 5.25% coupon, maturing on December 1, 2025.
The yield to maturity is 2.76%.
The yield to maturity is below the 5.25% interest rate because the bond is trading at about $1,100, which is $100 above par value.
So as long as you own the bond, you get paid 5.25% (tax-free) per year, or $52.50 per $1,000 bond. But at maturity, you’d lose $100 because you’re buying it at $1,100 and selling it at $1,000.
But the interest you realize in the form of $52.50 per year per bond (tax-free) means you still make money. At the end of the four years, your total annual return comes out to 2.76%.
And here’s a bonus: As I mentioned, the interest is tax-free. But capital gains on muni bonds are not. That means capital losses are deductible. So if you lost the $100 per bond, you can deduct that from other long-term capital gains while still collecting $52.50 per bond per year in interest tax-free.
Lastly, this particular bond out of Cook County can be called in 2023. That means, if Cook County decided to repay the bond early, it could – beginning in 2023. That would obviously reduce your total return because you’d still lose the $100 per bond and would collect only the $52.50 per year per bond through 2023 instead of 2025.
In that case, your total return would be 0.79%, which is certainly not great but not terrible in this ultra-low rate environment, especially when you consider the best two-year certificate of deposit (CD) rate is 0.8%, and that’s fully taxable. The 0.79% you’d earn from this muni bond is tax-free, and you’d also have the deduction for the loss, pushing your after-tax return even higher.
It’s important to remember that a CD is insured by the Federal Deposit Insurance Corporation. If the bank goes under, you get your money back. Muni bonds can be insured. The one mentioned here is not. Though things have to be pretty bleak for a muni bond to default (even though it is always a possibility). As I stated, 99.92% of all muni bonds pay back bondholders at maturity.
Muni bonds are a good place to stash some cash, particularly for those in higher tax brackets and/or high-tax states. And historically, you have a 9,999 in 10,000 chance of getting your money back.