One alternative to government bonds that have been extremely popular during these tumultuous times have been municipal bonds. Unlike Treasuries, all the interest you earn from municipal bonds is federally tax free. But the pandemic has made munis trickier to buy than usual because of the toll the virus has taken on state and local finances. So when does it make sense to buy munis today? Let’s take a look at the role munis can play in your portfolio.
When you buy a municipal bond or bond fund, you’re actually lending money to a state or local government to fund its operations or a special project such as a school, road or sewer system. The money to pay that bond back comes from taxes on the citizens or from revenues generated by that project, such as tolls. As an individual investor, you never have to pay federal income taxes on the interest you earn from municipal bonds. If you buy bonds from the state or city where you are a resident, you don’t have to pay taxes on that interest either. That makes those in state bonds either double or triple tax free. The higher your tax bracket, the more tax you avoid by buying munis, so the more sense they make compared to taxable Treasuries or corporate bonds.
High quality long term munis today pay in the 2 to 3 percent range which is much higher than the 1 percent or less being paid by Treasuries. In normal times, the default rate on munis is extremely small, typically about 1% or less, because governments want to maintain good credit ratings so they can issue more bonds. But that security has come into question recently because state and local governments are running such big deficits. The coronavirus shutdown has dramatically reduced sales tax, recreational fee income and other sources of revenue. Meanwhile, expenses have shot up dramatically because of higher unemployment costs, health care costs and overtime. Municipalities have gotten some money from the federal government, but not nearly to enough to bridge the gap. Many cities and towns have responded by laying off police, firemen and teachers. So far, there have not been any municipal defaults because of these financial pressures. But there is no guarantee that defaults won’t rise if this situation continues for a long time.
There is one simple solution if you still want to invest in muni bonds for that tax free income. That’s to buy bonds or bond funds that are insured against default. There are two major muni insurers–Assured Guaranty and Build America Mutual. They guarantee that you will get all interest and principal as due even if the underlying issuer does not pay it. You can buy an individual municipal bond that says in its name insured by AG or BAM, typically for a minimum of $25,000. For a list of some of the bigger insured muni bonds, look up the components of the Merrill Lynch Insured National Municipal Bond Portfolio. An easier way to buy a basket of insured bonds is through a mutual fund or exchange traded fund. For example, the IQ MacKay Shields Municipal Insured ETF, symbol MMIN, currently pays a yield of about 2.8% tax free. So now may be a good time to earn some significant tax free income from municipals. But if you’d like the belt and suspenders approach, it might make sense to try some insured bonds or bond funds so you don’t have to worry about defaults.