Municipal Bonds as an Investment Vehicle

The nation’s economic woes have affected all of us, but municipalities have been hit particularly hard resulting in cash-strapped state and local governments across the country. Consequently, you might be wondering how this situation could affect an investment class you might be considering: municipal bonds.

If you’re thinking about municipal bonds (munis) or if you already own some, you are aware of their key benefit — namely that the interest payments generated by munis are free from federal income taxes and in some cases state and local taxes as well. (Interest payments from some types of municipal bonds may be subject to the alternative minimum tax.) This tax advantage means that you’d have to earn a much higher yield on other types of bonds to match the “taxable equivalent yield” of munis. Typically, the higher your income tax bracket the more you’ll gain from investing in municipal bonds by possibly avoiding some income taxes.

In addition to their tax advantages, municipal bonds offer other benefits. For example, munis can help diversify an investment portfolio that may be heavily weighted toward stocks and corporate bonds. Also, by adding quality municipal bonds to your holdings, you can help support worthwhile projects in your community, such as construction or expansion of schools and hospitals.

Given these benefits, what’s the risk? Specifically, do you need to worry that the economic environment may affect municipalities’ ability to repay their bonds?

Historically,  municipal bond default rates have been much lower than those of corporate bonds, especially lower-quality corporate bonds. Of course what has happened in the past is no guarantee of future results. Many municipalities have responded to the fiscal crisis by cutting spending, eliminating nonessential programs and in some cases raising taxes.

They have ample reason for doing this, for in good times and bad municipalities still need funding for projects. If they defaulted even once on their current bond payments, they could find themselves unable to borrow money, in the form of new municipal bonds, for a long time.

Still, if you’re going to invest in municipal bonds, it’s probably a good idea to stick with those that receive ”investment grade” ratings from an independent rating agency, such as Standard & Poor’s or Moody’s.

Keep in mind that there are federal legislative proposals being considered that would cap the tax deduction on interest earned from munis. The measure now on the table would limit the deduction to 28%. Interest rate risk is also another consideration, but that is a topic for another article.

In any case, you should not automatically shun the municipal bond market just because times are tough for state and local governments. Talk to your financial advisor to determine if munis are appropriate for your investment strategy.

This article is provided by Eric St. Martin, a Senior Financial Associate at RBC Wealth Management in Stillwater, MN, and was prepared by or in cooperation with RBC Wealth Management.  The information included in this article is not intended to be used as the primary basis for making investment decisions nor should it be construed as a recommendation to buy or sell any specific security. RBC Wealth Management does not endorse this organization or publication. Consult your investment professional for additional information and guidance. RBC Wealth Management does not provide tax or legal advice.  For additional information, please visit www.neumanwmgroup.com or call 651-430-5535.

RBC Wealth Management, a division of RBC Capital Markets LLC, Member NYSE/FINRA/SIPC