Individuals are the single largest group of owners in today’s municipal bond marketplace.1 Why? Because municipal bonds are unique securities, generally offering investors features such as tax-exempt, predictable income and high credit quality on many issues.

Municipal bonds are tax-exempt2, fixed income securities that represent the debt obligations of municipal entities (states, cities, counties etc) seeking to raise money to fund projects for the public good, such as building schools, highways and hospitals. The issuer promises to repay principal in full at the bond’s maturity, and to pay semi-annual interest income – which is generally exempt from federal income tax, and in most cases, state and local taxes as well.

Is your Federal Income Tax Bracket 25% or Higher?
One of the most compelling reasons to own municipal bonds is that interest income is generally exempt from regular federal income tax. Under most state laws, ‘home-state’ municipal bonds’ interest income is also exempt from state and local taxes. As a result, municipal bonds may generate higher net (after-tax) yields than taxable bonds of similar quality and maturity.

Your federal tax bracket plays an important role in determining whether a taxable or tax-exempt security is the better choice for you.  As a general guideline, the higher your tax bracket, the more likely you are to potentially benefit from owning municipal bonds. As illustrated below, an investor in the 33% federal income tax bracket would have to earn a 6.72% yield from a comparable fully taxable bond to match a 4.50% yield from a tax-exempt municipal bond.

Tax-Exempt Yields v Taxable Equivalent Yields

	Federal Income Tax Rates
Federal Tax Bracket	25%	28%	33%	35%
Tax-Exempt Yield%	Taxable Equivalent Yield (TEY) %
3.50	4.67	4.86	5.22	5.39
4.00	5.33	5.56	5.97	6.15
4.50	6.00	6.25	6.72	6.92

For illustrative purposes only, and does not represent any specific investment

Nonetheless, when choosing any fixed-income security, you need to do more than just compare yields to find the bond that is most appropriate for you; an assessment of risk and return is also important:

Consider the Impact of Interest Rates
All fixed income securities are susceptible to interest rates fluctuations; generally, if interest rates fall, bond prices rise and inversely, if interest rates rise, bond prices fall. Because bonds are typically issued with prevailing market yields, rising market interest rates causes new issues to have higher yields than existing bonds, forcing down prices on existing bonds.  Generally, longer term bonds are more sensitive to interest rate changes, and the more likely their value is to fluctuate.  However, longer-term bonds generally have higher yields, thus compensating for the time principal is exposed to interest rate fluctuations.  Conversely, bonds with short-term maturities (up to a year) normally experience relatively minimal changes in price as interest rates fluctuate, but also typically provide lower yields.  Another point to consider: If you hold your bonds to maturity, your principal will be returned in full, yet, if you sell your bonds prior to maturity, the price you receive may be more or less than your original purchase price.

Credit Risk
You should consider every bond’s creditworthiness; if an issuer is unable to meet its financial obligations it may fail to make interest and principal repayments.  Although municipal bonds are generally considered to be high quality investments, not every issuer has the same tax base or sources of revenue.

Consider Call Provisions
Many municipal bonds have call provisions; the issuer has the option to redeem the bonds prior to maturity. If a bond is called, you bear the risk of reinvesting the proceeds at a possibly lower rate of return, depending on market conditions, potentially impacting your ability to plan your future income stream.

Are Municipal Bonds for you?
As well as generating tax-exempt income, the municipal market is attractive in terms of investment quality, maturity, sector focus, and geographical diversity.  Municipal bonds could be an important diversification and tax planning tool within your fixed income portfolio.  

¹ Source: Federal Reserve Board Flow of Funds Account, September 2008

² Municipal bonds are generally exempt from federal income tax. Typically, state or local tax-exemption applies if securities are issued within one’s state or city of residence. If you are subject to the Alternative Minimum Tax (AMT), interest on ‘private activity’ municipal bonds is considered a preference item. 

Articles are published for general information purposes and are not an offer or solicitation to sell or buy any securities or commodities. Any particular investment should be analyzed based on its terms and risks as they relate to your specific circumstances and objectives. Morgan Stanley Smith Barney does not render advice on tax or tax-accounting matters. Clients should always check with their tax and legal advisor before engaging in any transaction involving IRAs or other tax-advantaged investments. This material was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws.

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