Definition and Basics on Municipal Bonds and Municipal Bond Funds

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Definition: Bonds are debt obligations issued by entities, such as corporations or governments. Municipal bonds are bonds issued by government municipalities or their agencies. Examples include cities, states, and public utilities. The debt obligations are used to raise money to fund the building of schools, parks, highways, and other projects for public use.

According to InvestingInBonds.com when you purchase a municipal bond, you are lending money to a state or local government entity, which in turn promises to pay you a specified amount of interest (usually paid semiannually). The original amount of the bond you purchased (the principal) is returned to you on a specific maturity date.

Taxation and Tax-Equivalent Yield of Municipal Bonds

Most municipal bonds and municipal bond funds offer income that is exempt from both federal and state taxes. Municipal bonds typically have low relative yields; the interest received by a bond investor is often lower in relation to other bond types, such as corporate bonds. However, the tax-free status of municipal bonds can create a tax-equivalent yield that is higher than other bond types.

For example, a taxable bond, such as a corporate bond, that pays 5.00% may not be as attractive to an investor buying a tax-free municipal bond that pays 4.00%. To determine which bond is best, the investor can calculate the tax-equivalent yield. The tax-equivalent yield is the pre-tax yield that the taxable bond must pay in order to equal the tax-free municipal bond yield. The calculation is the tax-free municipal bond yield divided by one minus the investor’s tax rate. Here’s the calculation for an investor in the 35% marginal tax bracket, considering a municipal bond paying 4.00%:

Tax-Equivalent Yield = .04 / (1 — .35) = 6.15%

This calculation reveals that the income taxes saved by using the tax-free municipal bond is equivalent to (the same as) a taxable bond earning 6.15%. Therefore the bond investor is wise to use the municipal bond or municipal bond instead of the taxable corporate bond.

Who Should Use Municipal Bonds or Municipal Bond Funds?

It is important to note the difference between bonds and bond mutual funds. Individual bonds are typically held by the bond investor until maturity. The investor receives interest (fixed income) for a specified period of time, such as 5 years, 10 years or 20 years. The price of the bond may fluctuate while the investor holds the bond but the investor can receive 100% of his or her initial investment (the principal) at the time of maturity. Therefore there is no loss of principal as long as the investor holds the bond until maturity.

This is not the same as how bond mutual funds work. With bond mutual funds, the investor does receive the interest paid by the underlying bond securities held in the mutual fund. However the bond manager typically buys and sells the bond holdings, often at high frequency (see Turnover Ratio ). If bond prices are falling, the bond fund investor can lose principal even if they hold the mutual fund because the bond manager is still buying and selling bonds for the portfolio at prevailing prices. For this reason, some investors prefer individual bond securities to bond mutual funds when bond prices are expected to fall. Bond fund investors can also consider bond funds that can do well in rising interest rate environments .

The typical investor that use municipal bonds and municipal bond funds are those in high tax brackets. Also, it is not necessary to use municipal bonds in tax-deferred retirement accounts (e.g. IRAs, 401ks) where tax is deferred and therefore the tax savings are meaningless.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.