Investing

'Young people shouldn't reflexively avoid' this investment, which offers a tax break and protects your portfolio, expert says

"Munis" come with a tax break and can protect your portfolio. Here's why to consider investing.

Twenty/20

The classic investing advice, echoed by everyone from personal finance influencers on social media to Warren Buffett is some variation of "buy a diversified portfolio and hold your investments for the long haul."

It's smart to hold a mix of different types of investments, the advice goes, and if you're a young person investing for a long-term goal, like retirement, to tilt your portfolio heavily toward stocks. Stocks trend up over long periods and can net you higher returns than more conservative asset classes like bonds. And although stocks come with higher volatility, too, if you still have decades to accumulate wealth, you have plenty of time to recover from drawdowns in your portfolio.

But if you're investing for a shorter-term goal like, say, buying a home, it also helps to incorporate some less risky assets in your portfolio that can hold up if stocks suffer a slip. Investors setting aside money they plan to use in the next 5 to 10 years in a taxable brokerage account may want to hold a mix of stocks, cash, and municipal bonds, suggests Christine Benz, director of personal finance at Morningstar.

They offer benefits for older, wealthier investors, Benz says, "but young people shouldn't reflexively avoid them and assume they're for their grandparents."

Read on for an introduction to municipal bonds, any why it's wise to consider adding them to your portfolio.

Municipal bonds have a key benefit

As with any bond, when you invest in a municipal bond ("muni" for short), you loan money to the bond's issuer with the expectation of repayment on a set date, which is known as the bond's maturity date. In the meantime, you'll collect regular interest payments, which are expressed as a yield — the percentage of the bond's face value you're paid in interest.

In general, riskier bonds come with higher yields to compensate the investor for taking on the added volatility.

Munis are issued by state and local governments and can be thought of as loans used to fund public projects such as roads, bridges, and public transit systems. To thank you for investing in your community, the government has built a major benefit into muni ownership: The interest you earn on most municipal bonds is exempt from federal income taxes and, depending on where you live, exempt from state taxes as well.

If you hold munis in a tax-deferred account, such as a 401(k), the tax break won't do you much good, because you're exempt anyway. But for holders of taxable accounts, such as regular brokerage accounts, munis' tax advantage can make holding them more attractive than other types of bonds.

Municipal bonds are not just for the rich

Because interest from bonds, such as debt issued by corporations, is normally taxed as ordinary income, munis become more beneficial as an investor climbs to higher tax brackets, says Benz. "Higher-income folks will tend to benefit more from munis," she says. Still, they can be useful for younger investors, too.

Determining whether you earn enough for munis to be beneficial to your portfolio requires you to tabulate a muni bond's "tax equivalent yield," which shows you how high a taxable bond's yield would have to be to compete with your tax-exempt muni bond. An online calculator, such as the one provided by fund company Eaton Vance, will allow you to make this calculation based on the yield on your muni bond, your income, your state, and your tax filing status.

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Carrying out that calculation reveals that you don't have to be a Rockefeller to reap the benefits of muni bonds. Consider the following. The yield on the Bloomberg Barclays U.S. Aggregate Bond Index, a proxy for the broad taxable bond market, is currently about 1.2%. The yield on an index tracking California-based munis is 1.0%.

But if you're a Californian investor making just $35,000 a year, you avoid paying the 12% federal income tax rate plus the 6% state income tax rate by investing locally, and as a result, a taxable bond would have to yield 1.3% to compete with your basket of Golden State debt. If you make $50,000, owning the California muni index would give you a tax-equivalent yield of 1.5%.

Know the risks before you invest

Though bonds will tend to preserve your investing dollars when stocks falter, they come with their own set of risks. Chief among concerns for muni investors is interest-rate risk, says Justin Pfaff, managing director and municipals product manager at investing firm Nuveen. Because bond prices and interest rates move in opposite directions, an increase in interest rates (which are currently languishing near zero) erodes the price of your bonds.

A bond's interest-rate sensitivity is measured in duration — the higher it is, the more sensitive to rates the bond is. "For the main muni index we track, the duration is normally between five and six years," Pfaff says. That means if you held a fund tracking that index, a 1-percentage-point hike in short term interest rates would cause the price of your fund to fall by 5% to 6%.

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Average durations vary among muni bond funds. Benz suggests investing in a fund whose duration matches your desired holding period. "If you plan to hold for five years, look for a fund with a five-year average duration," she says.

You should keep an eye on credit quality as well. Bonds with higher credit ratings will come with smaller yields, but present a lesser chance of defaulting than riskier fare. Lately, with many state and local governments struggling financially in the wake of the pandemic, credit quality among many municipal issuers has dropped, Benz says.

Unlike Treasurys, which are backed by the U.S. government and therefore virtually guaranteed to reach maturity, munis do occasionally default on their debt, though at lesser rates historically than their corporate counterparts, Pfaff says.

How to invest in municipal bonds

To balance out the risks presented by any one specific bond, invest in mutual funds or exchange-traded funds that hold a broadly diversified portfolio of munis. An index-based ETF will come with the lowest cost, but you may also consider a fund managed by a pro who can choose from the more than 1 million unique muni bonds on the market. "The muni market is heterogeneous, nuanced, and fragmented," says Pfaff. "A bond issued by New York City is different than one that funds the BART in San Francisco. There are different risks."

Municipal bond funds can hold debt from multiple states (holders will qualify for federal tax breaks) or from a single state.

Regardless of how you choose to invest, beware of funds marketed as "high-yield," which typically indicates the portfolio holds low-rated "junk" bonds, says Benz. "Those are really only appropriate for people who have higher-quality muni exposure and want this as a little extra kicker," she says. "It's not something I'd be monkeying around with if I had a 5- to 10-year time horizon."

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