A Case for Tax-Free Bonds

 

By Jon Flynn

 

The financial crisis of 2008 will no doubt go down in history as one of the worst years ever for most investors.  A broadly diversified portfolio of investments that usually provides protection from severe losses, helped very little.  It just goes to show that when a crisis in the financial system occurs, that everything suffers together. This “baby out with the bath water” thinking has even hit tax-free bonds, which are usually considered a safe-haven.  Could this be an opportunity to consider tax-free bonds for your portfolio?  Let’s take a look…

 

Often called municipal securities, tax-free bonds generally provide income to the investor that is exempt from Federal taxes.  While that sounds great, it’s also true, that in normal times the interest rates paid on tax-frees are usually much lower than a taxable bond of a similar maturity. Although they often pay a lower rate, many affluent investors who are in high tax brackets find them attractive.  The opposite is usually the case for the average Joe, who would be better served during normal times by plain old taxable bonds.  Well, like I mentioned earlier, these aren’t normal times. 

 

The decline in the prices of tax-free bonds in 2008 has led to a huge increase in tax-free yields.  It’s not uncommon to find intermediate term Pennsylvania municipal bonds with rates north of 4.5%.  And the income you receive in most cases is exempt on all three levels of taxation, federal, state, and local. This tax-free rate is now higher than many taxable investments that carry a similar risk profile.

 

You’ll find that not only is the absolute rate higher, but the taxable-equivalent-yield is dramatically higher as well.  The taxable-equivalent-yield is a formula that helps you determine what rate you would need to receive from a tax-free investment to beat the rate of a comparable taxable investment. 

 

It’s calculated as follows, Tax-exempt yield / (1- tax bracket). 

 

For example, let’s say you can find a municipal bond that pays 4.5 % and you’re in a modest 25% tax bracket.  Your TEY works out to 6.00% calculated as follows .045 / (1-.25).  This means that you would need to find a taxable bond paying 6.0% or more to work out better than a 4.5% tax-free bond!  Finding a 6.00% rate on a taxable bond matching the safety characteristics of a municipal bond would be very difficult in today’s environment.

 

 With bank rates at historical lows, and treasury rates at almost negative yields, it may make since for some to consider municipal bonds.  Sure, there’s nothing like the absolute guaranty that a federally insured investment like a bank CD or a Treasury can provide, but they are barely paying enough to even cover inflation.  Many municipal bonds come with their own assurances as well.  Some even carry private insurance to guaranty principal and interest. 

 

The bottom line is that everybody situation is different and arriving at solutions can get complicated.  So always consult with financial, legal, and tax professionals before making any decisions.

 

 

Jon Flynn is a Certified Financial Planner ^TM and owner of Flynn Financial in Eynon. He is a Representative of Securities America, Inc., Member FINRA/SIPC and of Securities America Advisors, Inc. Flynn Financial and Securities America are unaffiliated.   Mr. Flynn can be reached at 570-876-5015.