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What are Muni Bonds? And Should I Own Any?

A reader writes in to ask:

“I use Vanguard’s Total Bond Market Index Fund for my bond allocation, but I noticed that it doesn’t include any municipal bonds. Can you walk us through municipal bonds — how they work, who should own them, where you should put them (taxable account? IRA?), and which ones should you own (e.g. a general fund or a state-specific fund)?”

Bonds issued by U.S. states or municipalities are exempt from federal income tax. These bonds are referred to interchangeably as tax-exempt bonds, municipal bonds, muni bonds, or even just “munis.”

Because of their tax-exempt status, the market typically prices muni bonds so that they have lower yields than taxable bonds of a similar credit quality.

Who Should Use Muni Bonds?

Tax-exempt bonds only make sense when investing in taxable accounts. In other words, if all of your investments are in tax-sheltered accounts — 401(k), IRA, etc. — your investments are already protected from taxes, so there’s no reason to accept municipal bonds’ lower yields.

But even for investors who can’t tax-shelter all of their investments, muni bonds still aren’t necessarily the best bet.

Because of stocks’ built-in tax-efficiency (due to the maximum 15% tax rate on dividends and long-term capital gains), it generally makes sense to tax-shelter all of your bonds before tax-sheltering any of your stocks. As a result, municipal bonds typically only make sense if:

  1. Your desired bond allocation is larger than the amount of tax-advantaged space you have, and
  2. You’re in a high enough tax bracket that your after-tax yield on taxable bonds would be less than the yield on muni bonds of similar credit quality.

Example: James has $300,000 in a taxable account and $100,000 in an IRA. His desired allocation is 60% stock, 40% bond (that is, $240,000 stocks, $160,000 bonds for his $400,000 portfolio).

Even after James invests his entire IRA in bonds, he still needs to own $60,000 of bonds in his taxable account in order to satisfy his desired bond allocation. If James’ marginal tax rate is high enough, muni bonds could provide a higher yield than the after-tax yield on similarly-rated taxable bonds.

Of course, as with all broad investing guidelines, there will be exceptions. For example, an investor in a high tax bracket might want to own muni bonds in a taxable account and stocks in her retirement plan at work if the retirement plan has inexpensive stock funds but only super-high-cost bond funds.

Should You Own a State-Specific Muni Bond Fund?

While municipal bonds are exempt from federal income tax, they’re usually subject to state income tax. However, if you buy a bond issued by your own state or by a governmental body within your state, the bond will usually be free from state income tax as well.

State-specific muni funds (e.g., Vanguard California Intermediate-Term Tax-Exempt Fund) exist in order to invest in bonds within a particular state to take advantage of this exemption from state income taxes.

So, if you have a high state income tax rate, there’s a significant tax advantage to sticking with muni bonds from your own state. The downside is that you’d be sacrificing some degree of diversification.

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  1. Good question. I was curious about this as well. Any examples of municipal bonds that are readily available for purchasing in something like an index? A friend of mine claimed that he had access to muni bonds because of his financial advisor and that normal investors would not have access, but I can’t believe that that is the 100% true.

  2. Micah,

    He’s likely right. But it’s not necessarily an advantage. In fact, it’s possible that he’s getting ripped off relative to what he could get via a low-cost muni fund.

    When muni bonds are issued, they’re typically underwritten by a few different brokerage firms. So, right at the outset, only those brokerage firms will be able to offer that particular bond to their clients.

    And when an investor sells an individual bond, it’s often the brokerage firm itself that buys it from the investor. (As opposed to stock trades where the brokerage firm just plays matchmaker between a buyer and a seller.)

    In other words, at any given time, every brokerage firm will have different muni bond inventory than every other brokerage firm. So, for instance, if your friend’s advisor is an Edward Jones broker, then your friend has access to bonds that those of us who use Vanguard, Fidelity, or Schwab probably don’t have access to. At the same time, we’d have access to bonds that he doesn’t have access to.

    For investors buying individual muni bonds, it’s important to look not only at a brokerage firm’s quality/quantity of bond inventory, but also at what level of markup they charge on their bond trades. I know when I worked at Jones, markups in the 2-3% range were common on their inventory.

    In many cases, a low-cost muni fund will have lower overall costs than a portfolio of individual muni bonds. And, of course, it’s a lot less work.

    Also, this related article from Allan Roth may be of interest.

  3. Mike,

    I feel that any conversation of municipal bonds would not be complete without a mnetion of credit risk. American has recently seen a sharp increase in muncipal bankruptcies. Additionally, while States are not currently allowed to declare bankruptcy, there are indications that they have been seeking new ways to do exactly that, which this NY Times article documents:

    Additionally, 60 Minutes ran a special on this very issue in December 2010:

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