If you believe in Santa Claus and the "free lunch" concept, then you too will fall for the sales pitch that municipal bonds are a real bargain these days.
Yields are determined by markets. Market professionals figure out how much risk a certain security carries and what the proper reward should be for that risk. Thus yield becomes a fairly good determinant of what the risk factor is for a given security.Have you looked at the yields on municipal bonds lately? Did you notice that some of them are paying as much as 90 percent or more than Treasury securities? And, since the interest on municipal bonds is not taxable while the treasuries are taxable for federal income tax purposes, that means that if a municipal bond is paying 9 percent tax free, its taxable equivalent yield is 13.4 percent in a 33 percent tax bracket.
The astute investor will immediately ask, "Where's the alligator in the pool?" Why would a bond guaranteed by a certain municipal project be paying as much on a tax equivalent basis as a junk bond? The answer is quite complex, but some of the common denominators include:
- With a municipal bond, the buyer assumes the interest rate risk, not the issuing agency. That means that if interest rates go up, the investor loses part of his capital if he wants to sell. However, since most municipal bonds are callable, if the interest rates go down, he is exposed to the substantial loss. The municipality will refinance the issue at a lower rate and give the investor the face value of the bond, which may be less that what he paid for it. In other words, the investor has a chance of losing his money, but doesn't have an equal chance of making a profit.
- Most municipal bonds are guaranteed by the revenue of a specific local project. There are some "general obligation" bonds around, but they offer a lower yield because the payback is guaranteed by the taxing authority of the municipality, whereas the revenue bonds are strictly dependent on the success or failure of that specific project. That means that if the project goes broke, you don't get your money, even though the municipality might be prosperous and financially healthy. This has happened many times in the past.
Because of this, there are insurance organizations that insure your principal in case the project does go broke. You pay for this insurance by getting a much lower yield, but if you want to have a fighting chance of getting your money back, you shouldn't buy a municipal bond without insurance.
- Ever since tax reform, there's been steady pressure to balance the federal budget by raising taxes. A tax hike would have a lot of impact since most of the deductions against earned income have been limited or eliminated. Since municipal bond interest isn't taxable for federal tax purposes, many consider this one of the remaining tax loopholes for the rich. Your guess is as good as mine whether the tax-free status of municipals will continue.