Investing in municipal bonds
Municipal bonds offer possible income tax exemptions in the fixed-income side of a diversified investment portfolio, Dave Sandstrom explains in a Money Talk Video interview with Joel Dresang.
Joel Dresang: Dave, when we talk about diversifying an investment portfolio, we talk about diversifying within the different portions as well. Today, let’s talk about the bond portion and specifically about municipal bonds. How do you explain what those are?
Dave Sandstrom: Municipal bonds are issued by local governments. So it could be a state, city, county governments, to fund obligations or fund projects for the general public use. So it could be hospitals, highways, bridges, power plants, utilities, that type of thing.
Joel: And there are different types of municipal bonds, right? So the most common are the general obligation and the revenue bonds. What are the differences there?
Dave: The general obligation bond is exactly what it sounds like. It’s used to fund the general obligations of the municipality. The reason it’s considered to be safer is that it is backed by the faith and full taxing power of that municipality.
Revenue bonds are tied to a specific project. The obligation is funded by the revenue generated by the project. It could be maybe a toll bridge or a hospital. And if, for some reason, that particular project were to fail, then the bondholders are on the hook. The municipality can’t just turn to the public there and say, “Okay, we’re raising taxes to pay for this now.” It doesn’t work that way.
The other thing to consider is that a revenue bond, because it’s a little riskier, deemed a little riskier, the yields are typically a little bit higher than the general obligation bond.
Joel: Generally, why would investors want to own municipal bonds?
Dave: Municipal bonds offer a great way to diversify your portfolio, especially on the fixed-income side. They tend to react a little differently to market conditions than corporate bonds or Treasurys would.
But the most important reason, I think, and the most attractive reason is that they’re typically exempt from federal income taxes – the income that’s generated. Definitely a big advantage, depending on your income tax level to avoid that taxation on that income.
Now, generally a rule of thumb that we like to subscribe to is that once the municipal yield gets to be about 80% of the comparable Treasury yield, then it’s generally worth taking a look at.
Joel: Dave, as for the tax exemption, the higher your tax bracket, the more you would benefit, so it would be better to have this in a taxable account, and not like in a 401(k) or an IRA. And you’re still subject to the capital gains tax.
Dave: It’s a really important point to realize, Joel, because a perfect example is this past year, we saw a tremendous price appreciation in a lot of municipal issues, and when you sell that and realize the gain, that is taxable. So it’s just the income that’s federally income tax free.
Joel: What about the risks associated with investing in municipal bonds?
Dave: Muni bonds carry similar risks to other bonds in the fact that they carry interest rate risk. The fluctuation in interest rates will impact them. And then there’s also credit risk that you need to consider. However, historically – especially in general obligation bonds – the default risks have been very low.
But it doesn’t mean that you’re completely out of the woods. Recently, we’ve seen stories like what’s happened to Detroit, what’s happened in Puerto Rico, that have given some fear to the industry. But keep in mind that there are literally tens of thousands of municipal issues across the country, and you’re only talking about a handful of them that have done very poorly.
Joel: So, is there a good way to diversify among the municipal bonds that you hold?
Dave: I would recommend, if you’re going to gain exposure to municipal bonds, look to a quality mutual fund to do so, for the very reason that they’re going to diversify you across hundreds of issues – to avoid that one that goes bad. In addition to that, you’re going to be employing a manager in that fund that is going to be doing due diligence on all of the issues, spending a lot of time and effort to steer you clear of the trouble spots.
Dave Sandstrom is a vice president and investment advisor at Landaas & Company.
Joel Dresang is vice president- communications at Landaas & Company.
Money Talk Video by Peter May
(initially posted Feb. 20, 2015)