I recently had a friend ask me where they should invest given the current market volatility. My go to advice is to just keep investing into the stock market by buying indexed passively managed ETFs. I especially like doing this on days when the markets are down. But I didn’t tell my friend to do that. I know he, like me, is well invested into the stock market. I told this friend to consider buying municipal bonds.
The market is near all time highs and I have been harvesting some of our gains. Typically, I’d re-deploy this cash back into the stock market during a pullback or correction. However, I’ve been looking into redeploying capital into the bond market. Bonds are middling right now and the Fed seems close to pulling the trigger on lowering rates. When the Fed drops rates, the higher yield on bonds issued before the rate drop will become more attractive.
It’s important to note that I’m not providing specific investment advice. I am providing general information and entertainment. The information provided in this article is not specific advice to anyone, just informational.
This means that the price of bonds issued before the rate drop will start trading at a “premium” or above their par (original) value. Before interest rates drop, it could be a strategic play to start buying bonds now. Not only would we benefit from a higher yield, we would also benefit from the appreciation in the bond price.
Plus, we’re starting a point in our lives where we would like to build up a source of reliable income. Over 90% of our portfolio is in individual stocks, total stock market or S&P index funds. This has been by design. We wanted to capture the growth side of the market and have been very risk tolerant. We still are heavily invested in stocks and plan to remain that way. However, we will need a reliable source of income and bonds offer that.
But…buying bonds is intimidating
Buying bonds seems pretty intimidating. There’s a whole different nomenclature. Words like par value, investment grade, junk, premium, discount, high yield, coupon etc. And there are many kinds of bonds: corporate bonds, iBonds, savings bonds, treasury bonds, junk bonds, etc. For the scope of this post I want to focus on a particular kind of bond; tax exempt municipal bonds.
Municipal bonds are an often overlooked investment. It’s because they’re difficult to understand, and carry higher risk.
What are municipal bonds?
Municipal bonds, or “munis,” are bonds that are sold by state or local governments to fund various local public projects. Projects like building new schools, roads, water treatment plants, etc. Munis are much like treasury bonds. You’re lending a government entity money in exchange for an interest payment (income). Munis often offer higher interest rates on their bonds. Unlike U.S. federal treasury bonds, they aren’t backed by the full faith and credit of the U.S. government. They are instead backed by local and state governments. Because of this they are considered to have a lot more risk associated with them. There is more risk of not getting your money back or receiving interest payments.
So if there’s more risk why invest in municipal bonds?
The reason you may want to invest in municipal bonds is because they offer a higher interest rate than U.S. treasury bonds. As mentioned, municipal bonds are considered higher risk. Because they are considered higher risk, they have to offer benefits to compensate for that. Often, municipal bonds offer higher yields on their bonds as compensation for being a riskier investment than treasury bonds.
Another benefit on municipal bonds is that their yield (the interest payment you receive for being a bond holder, i.e. income) is tax-exempt at the federal level. Many states also do not tax in-state municipal bond income. If you’re in a high tax bracket, buying municipal bonds could help you create a tax-free source of income. Depending on the state you live in, and the bond, you may not have to pay both federal or state income taxes. That could be huge for those individuals living in high income tax states like New York, New Jersey, Illinois or California (to name a few).
Let’s take New Jersey for example
Not having to pay federal or state income tax in New Jersey could be a boon for NJ high income earners. New Jersey has several municipal bonds ranging in yield from about 3.03% for short term bonds to over 4.8% for long term bonds. Not wholly exciting rates. But, if you’re in the top federal and state tax bracket in New Jersey you have a 47.75% marginal tax rate. Resident New Jersey muni bond holders are exempt from federal and state tax. That’s a potentially clean 4.8% return. That’s like getting a 9.18% yield on a fully taxable investment.
The 9.18% rate is what’s called a “Tax Equivalent Yield.” It basically tells us the taxable yield you’d have to receive in order to match the tax exempt rate. Last I checked, it was pretty near impossible to get a consistent 9% yield. But you can get the tax equivalent through munis.
But Mrs. Moneyaire, some states still charge state income tax on their local municipal bonds…
True, not all states tax municipal bonds the same way. Illinois, for example, charges state income tax on many state and lower governmental municipal bonds. So, in this state, if you’re a resident and purchase Illinois bonds or bonds from lower governmental agencies within Illinois, you’re very likely to still owe state income tax on the interest payments you receive. The upside is that federal tax is not due on them. There are some bonds that Illinois issues that are state and federal exempt, but they are harder to find, and have a less desirable credit rating and yield.
Municipal bonds also open you up to the scary Alternative Minimum Tax. If you get hit with this, the top tax bracket is 28% but you’re allowed fewer deductions. This happens when high income earners buy munis considered “private activity bonds” (PAB) – so buyer beware. I personally would want to stay away from these bonds and stick to general obligation bonds.
There is a muni bond type that allows you to skirt state tax AND the AMT. They’ll also offer a higher interest rate than most state munis and federal treasury bonds — if you’re open to more risk.
Municipal bonds from U.S. territories
Bonds from U.S. territories like Puerto Rico, Guam, and the U.S. Virgin Islands are both state and federal tax exempt. Plus, Section 103(c)(1) of the Internal Revenue Code excludes interest on bonds issued by U.S. territories from AMT treatment — even if they are private activity bonds.
Plus, they often times offer a higher yield than many bonds issued by the contiguous states, Alaska and Hawaii. This is because they are seen as much riskier. Puerto Rico has defaulted on its bonds recently and has ongoing financial uncertainties. Puerto Rico, Guam and U.S. Virgin Islands are also islands in hurricane or typhoon prone areas. Climate change heavily impacts these islands and investing in their bonds is riskier because of this.
If the risk of default doesn’t scare you, these bonds are pretty easily found for sale at brokerages like Fidelity or Schwab. However, you have to be very aware of bond price, yields, duration and credit ratings to make a good pick when it comes to buying bonds in general let alone U.S. territory bonds.
Is the point of this post to leave the reader disappointed by Munis?
Sorry if I got you excited and then let you down with the talk of defaults, AMTs, state tax surprises, and the general difficulty of buying individual municipal bonds. There’s a way to buy into munis the easy way – buying a bond fund.
Specifically, buying a municipal bond fund. My favorite municipal bond fund is HIMU. I love that it offers an SEC yield of 5.18%. Its an actively managed fund (which I don’t like) and has a .42% management fee (eww). I like when a fund’s fees are .2% or below. I’m overlooking this fee because the income from this fund is tax exempt at the federal level. And even though it’s not state tax exempt in many states, or only partially so, it still beats out state specific funds that are state tax exempt. There’s about 15% turnover in this fund. This means there isn’t a constant churn of bonds within the fund causing higher costs and potential capital gains taxes.
I’m also stomaching this fee and the added risk because I like that it’s diversified. This fund is made up of 795 bonds from about 40 states and U.S. Territories. The biggest individual bond makes up about 3.4% of the fund and no state represents more than 11% of holdings. So, although this is a high yield muni fund, the risk of defaults (I believe) is managed well. Some bonds in this fund are PABs so the risk of running into the Alternative Minimum Tax remains a risk. However, from what I can ascertain, PABs make up a small percentage of bonds in this fund.
Are there state specific municipal bond funds?
There are state specific muni bond funds. New Jersey and Illinois have two that I’ve highlighted below. They allow holders federal and state tax free income, plus they have low fees. Both are at Vanguard. However, after considering fees, SEC yield, state taxes, HIMU still comes out ahead. Here’s a comparison of a $10,000 investment in HIMU and a New Jersey and Illinois specific muni fund:
Great, so should I stuff my 401k with HIMU?
No. Don’t do that. Instead consider dedicating some of your post tax brokerage dollars towards a fund like HIMU. Instead of buying CDs, or hoarding cash in a HYSA where you’ll be charged ordinary income, consider HIMU in a post-tax brokerage. HIMU doesn’t really make sense to purchase via a pre-tax account like a 401k, HSA or IRA. This is because the special tax treatment for HIMU would become irrelevant when you take a distribution from those accounts.
Also, don’t put this into a Roth. The tax treatment there wouldn’t provide the benefit we’re trying to achieve, i.e. avoiding paying income tax on income. The bond fund I like buying in my pre-tax accounts is USHY. More on this fund in a future post. Make sure to subscribe so you get that post when I publish it.
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Is HIMU right for you?
I don’t know. I do know that after researching my options it’s a good choice for me. I’m looking to start building up the income producing side of my portfolio and reduce my tax exposure. I want this part of my portfolio to be more resistant to big down swings in the stock market. When Mr. Moneyaire retires, we’re going to need a base level reliable income stream. Having a federally tax-exempt income from high yield municipal bonds in our post-tax brokerage account is going to be part of our strategy.
I plan to have the majority of our investments in stocks. Stocks will far outpace bonds in terms of appreciation. Though I’ve avoided them until now, the right bonds and bond funds have a place in our portfolio, too. Bonds will provide a bit more reliability than stocks when it comes to income. Time to start building that up for our family.
