Should You Use Tax-Free Municipal Bonds in your Portfolio?

Municipal Bonds are debt securities issued by states, cities, townships, counties, or school districts to finance large capital expenditures.  These bonds are typically used to finance projects such as the construction of roads, airports, schools, or hospitals.  As the owner of a bond, you receive coupon payments twice a year, until the bond matures. For example, if you owned $10,000 worth of a bond that yields 2.5%, you would receive coupons of $125, twice a year.

Income generated by municipal bonds is considered “tax-free” by the Internal Revenue Service (IRS).  This is compared to bonds issued by corporations (Corporate Bonds) or by the US Treasury (Treasury Bonds) whose income is taxable.  However, municipal bond funds historically offer lower yields versus comparable corporate bonds.   For example, a popular municipal bond fund, iShares National Muni Bond ETF (MUB) has a yield of 2.17%.  This yield would be received by the investor income tax free.  A comparable taxable bond fund we use is SPDR® Portfolio Aggregate Bond ETF (SPAB), this fund has a yield of 2.97%.  Both funds have a similar credit risk and similar interest rate risk (duration).

Is it worth receiving a lower yield if the income is tax free? It depends on what tax bracket you are in.  Those in a higher tax bracket may receive a higher after-tax yield by using municipal bonds versus corporate bonds.  At Hyland Financial Planning we conduct an analysis for each one of our clients to see if the additional of municipal bonds would boost the after-tax return of their portfolio. 

In this case, investors in the 32% tax bracket and above would have a higher after-tax yield if they used a municipal bond fund over a taxable bond fund. (2.97% x (1-32%) = 2.02%).  If a client's tax bracket is any lower than this, it would make sense to use the taxable bond, as even after taxes, you would still have a higher yield.

For single filers that made over $157,501 or married filers that made over $315,001, we use municipal bonds in their portfolio.  For clients with incomes under these amounts, we used taxable bonds.

If you have any questions regarding municipal bonds or your investment portfolio, reach out to Hyland Financial Planning using the link below!