I often get questions from people who either "want" tax free income or wonder if Municipal Bonds will help them save on taxes. What I often find is that when an individual investor "wants" something it is because somebody convinced them that they need it. Usually, that somebody is trying to sell the exact thing. Municipal Bonds are an easy sell, they provide:
1. Income that is free from Federal taxes and free from state taxes if you buy Munis in your state.
2. They are not as volatile as stocks
In this environment who wouldn't want an investment that is tax free and doesn't fluctuate like stocks?
However, if you look at these issues in more detail Municipal Bonds end up not looking that good.
First, lets look at tax free income. If I gave you the choice between a bond that would pay interest of $100k that was taxable or a bond that would pay interest of $100k that was tax free which would you want? Easy answer, all things being equal you choose tax free. Now I know what you are thinking, Muni's typically yield less than other types of bonds so you have to look at tax equivalent yield (TEY). So in my example above, lets say I gave you the choice between $100k taxable or $70k tax free. To get the TEY you divide the $70k by 1-your tax rate, if you are in a 35% tax bracket then the $70k is really work $107k, so the Muni bond is better right? That's what the salesman wants you to believe but we are still missing the most important issue----how much money do you have in your pocket at the end of the day.
The return from a bond is more than just interest payments, it is also capital appreciation or depreciation. If I earn $100k of interest but lose $500k of principal then I have a net loss of $400k. When looking at any investment their are three key questions you need to ask yourself:
1. Can I lose money?
2. If so, how much?
3. Am I being paid enough to take that risk?
As of 7/16/12 the yield on the Merrill Lynch 7-12 yr tax exempt index is 1.78%. Forget about TEY for a minute and think about this, I am being paid 1.78% tax free to take the following risks:
1. My bond(s) might go bankrupt. Look at all the states declaring bankruptcy and the problems that states are having with their budgets.
2. Interest rates will increase making my principal go down.
These risks are very real possibilities. Is 1.78% tax free worth it to take these risks? No.