fixed income  |  march 9, 2021

Are Tax-Free Municipal Bonds a Good Fit for Your Portfolio?

Tax benefits and diversification make munis appealing to long-term investors.

 

Key Insights

  • Munis can provide a potential income stream that is tax-free at the federal level.

  • The two main types of munis, general obligation bonds and revenue bonds, carry different risks.

  • Munis traditionally have a low default rate and offer diversification benefits to investor portfolios.

Hugh McGuirk

Head of Municipal Bond Investing

Municipal bonds (munis) issued by states and localities provide investors with tax-free income potential and the benefits of diversification—important aspects of a long-term investor’s portfolio. In general, demand for munis has been robust in recent years despite news about troubled issuers and challenges related to the coronavirus. It is rare for a municipality to default or miss a payment to bondholders, which is one of the biggest reasons why these investments remain attractive to investors.

What Are Munis?

Municipal bonds are debt obligations issued by cities, counties, states, and other government entities. They are used to fund infrastructure projects, essential services, and other endeavors that serve the public interest. There are two main types of munis:

  • General obligation (GO) bonds are backed by the issuer’s ability to raise money through taxes and may support efforts such as school and road construction.

  • Revenue bonds are issued by a government-related entity to fund a project, such as a hospital wing. Revenues generated by those entities are used to pay the interest and principal to investors.

What Are The Benefits to Investors?

Munis offer investors a potential income stream exempt from federal income taxes. Income generated by munis issued in an investor’s home state is also typically exempt from state income taxes.

Keep in mind that these tax advantages apply when munis are held in taxable accounts. Muni yields are typically lower than pretax yields on taxable bonds with comparable credit ratings and maturities. (See “A Primer on Tax-Equivalent Yield”). As a result, they may not make sense in Traditional and Roth IRAs. Some interest income may be subject to state and local taxes as well as the federal alternative minimum tax. In addition, any gain on the sale of a muni bond in a taxable account is still subject to capital gains taxes.

While you can choose from a wide array of muni issues, you should consider investing in municipal bond mutual funds to achieve greater diversity in your holdings. These funds also enable investors to benefit from the expertise of professionals who perform essential credit research. Of course, diversification cannot assure a profit or protect against loss in a declining market. All mutual fund investments are subject to market risk, including the possible loss of principal.

A Primer on Tax-Equivalent Yield

Investors are often willing to accept a lower yield compared with the pretax yield on a similar taxable bond. To see the pretax yield you would have to earn on a taxable bond to equal a 2% tax-free yield on a municipal bond, select your federal tax bracket below.

This bar chart shows the tax-equivalent yield (%) based on tax bracket denoting a 2% tax-exempt muni yield. At a 22% tax bracket the tax-equivalent yield % is 2.56 and respectively: at a 24% bracket it is 2.63%, at a 32% bracket it is 2.94%, at a 35% bracket it is 3.08%, and at a 37% it is 3.17%.

*Does not include the 3.8% net investment income tax (NIIT); see irs.gov for more information. Chart also does not reflect any potential state or local tax benefit. Note that factoring in the NIIT and state and local income taxes, where applicable, would result in higher taxable-equivalent yields.

What Are the Risks?

Like other investments, munis carry risks. For instance, although interest rates have remained low in recent years, rising rates will cause bond prices to drop.

Muni investors should also be mindful of credit risk. While the fiscal challenges of 2020 have garnered headlines, municipal bankruptcies historically have been relatively rare. When defaults have occurred, they have represented a minuscule portion of a large market. Additionally, the muni market typically recovers quickly following an event that pushes away investors.

Although the muni market is overwhelmingly high quality, many GO issuers are struggling with underfunded pension obligations. In this environment, T. Rowe Price portfolio managers generally favor revenue bonds, which typically offer higher yields than GO bonds and have less exposure to pension liabilities.

However, investors must assess whether individual projects will be financially viable and fully understand how deals are structured, which underscores the importance of fundamental credit research. Regardless of market conditions, municipal bonds continue to play an important role in a well-designed fixed income portfolio.

Consider the investment objectives, risks, and charges and expenses carefully before investing. For a prospectus or, if available, a summary prospectus containing this and other information, call (800) 401-1819 or visit the T. Rowe Price Bond Funds page. Read it carefully.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of November 2020 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only. Actual outcomes may differ materially from expectations or forward-looking statements.

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