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Advantages and Disadvantages of Muni Bonds

Investing, Traditional Stock Investing

Generally speaking, bonds which don’t require too much investment (such as municipal bonds) are ideal for investors. That said, every investor and their portfolio have different kinds and combination of requirements. As an investor, you must consider all the advantages and disadvantages of municipal bonds in order to judge their appropriateness for your portfolio.

The following are the key advantages of municipal bonds:

Interest gained from Municipal bonds is mostly exempt from federal, state and even local income taxes:

Generally, an investor’s marginal tax bracket is the instrumental factor in deciding whether or not to invest in municipal bonds.

As an investor, it is always a good practice to first compare the yield of a muni bond with any comparable taxable bond’s after-tax yield. In order to do so, you must calculate the taxable equivalent yield of the muni bond. And in the event that the municipal bond you plan to invest in is not issued in the state of your residence, you should make the requisite calculation by equaling the taxable equivalent yield with the tax-exempt interest rate divided by one minus the marginal tax bracket. For example, if you are planning to invest in a municipal bond that has a yield of 4.5%, and your tax bracket is 25%, the taxable equivalent yield will end up being 6.0% (obtained by dividing 4.5% with 1 and then subtracting 25% from the same).

Municipal Bonds are available in a variety of choices:

Given that there are over 1.5 million outstanding issues of municipal bonds, one can easily determine the fact that bonds with all sorts of characteristics and combinations are available for investors to choose from.

Municipal bonds have high credit ratings in general:

While there are very few cases of municipal bonds defaulting, it is not entirely unheard of. As an investor, therefore, you must take the time to carefully review the credit quality before you go ahead and invest. In such situations, sticking with investment grade ratings is a good idea, since it indicates that the issuer is financially stable and therefore is unlikely to default.

As is the case with every type of bond, muni bonds too have some key disadvantages:

They cannot work with every portfolio-type:

Generally speaking, munis are not ideal for tax-advantaged plans such as 401(k) and individual retirement accounts (IRAs). This is due to the fact that municipal bond interest is exempt from federal income taxes, which means that you as an investor won’t gain anything by placing the bond in a tax-advantaged medium. On the contrary, the interest income, when withdrawn will be subjected to normal income taxes.

Municipal bonds can be redeemed even before they mature:

Having call provisions gives the issuer the power to redeem muni bonds before they mature. That said, the precise provisions vary from one type of muni bond to the other.

As an investor, you should review the provisions very thoroughly before you purchase a bond. Although doing so won’t allow you to stop an issuer if and/or when they make a call provision, it does allow you to purchase bonds with call provisions that are the best for you.

Usually, early redemptions occur when the market interest rates are lower than the interest rate of the bond. While you will the principal and maybe even a premium, the money will have to be reinvested later during a time when the interest rates are lower than what is paid on the original bonds.

Muni bonds remain subject to select taxes:

Although muni bonds are usually exempt from federal (and sometimes even state and local) income taxes, selling the bond prematurely can – and does often result in taxable gains. Furthermore, some bonds pay interest income that is subject to the alternative minimum tax (AMT).

Additionally, one should also consider local and State taxes in the event that the muni bond has not been issued in the state of your residence.