Muni Basics

Interest in municipal bonds is seasonal. Every year around this time Americans are reminded how much they pay in taxes and naturally turn their attention to finding ways to pay less. Munis, bonds issued by states, local governments, 1040 assorted agencies, and blessed institutions of same, are a popular place to look. You generally do not owe federal income tax on the interest you get from them, and if the bond was issued inside your own state you generally do not owe state income taxes either.

This being the season, there has been a flurry of discussion about investing in munis.  (See for example this in the Wall Street Journal.) Not to be left out, here is my primer on the subject.

The first thing to ask yourself before you consider munis is whether or not your income tax rate is high enough to bother. Yes, if you are paying any taxes at all, tax-free interest is better than taxed interest, everything else equal. But everything else is rarely equal in the investment world. Most muni investors are in the very highest tax brackets and they bid the prices up (and the yields down) such that munis make sense only for those paying those highest tax rates.

To make heads or tails of what munis might mean for you, it is useful to calculate the taxable equivalent yield. The formula for that is the tax-free yield divided by 1 minus your tax rate: I% / (1 – T%).  So a 4% tax-free yield with a 25% tax rate is the equivalent of 5.33% taxable. (Just as reasonably, you could convert taxable yields into after-tax terms by multiplying by 1 minus your tax rate, but that’s just not the way it’s done.)

So, imagine you are deciding between a taxable bond yielding 5% and an otherwise similar muni yielding 3.5%. Which one is the better deal will depend on your tax rate. If you are paying 25%, then the taxable equivalent yield for the muni is only 4.67%, so the taxable bond at 5% is still a better deal. On the other hand, if your tax rate were 40%, then the taxable equivalent for the muni would be 5.83%, making the muni a better deal.

The yields on munis are, like all bonds, often compared to the yields on risk-free Treasuries of similar maturity. That is a useful benchmark, but it is very important to keep in mind that munis are not risk-free. Defaults are rare, but they do happen. Not only do states and cities lack the power to print money, which is what ultimately backs up Treasuries, but they cannot be forced into a liquidation to pay off creditors. So, as a general rule, you would expect munis to pay a little more than Treasuries after the tax effects are factored in. Indeed, for the more dangerous issuers, e.g. California, yields are much higher than equivalent Treasuries to compensate for the additional risk.

As with stocks, there are two obvious ways to own munis. You can buy individual bonds or buy a share in a bond fund. And many of the same arguments about picking individual stocks versus buying stock mutual funds apply. Picking bonds yourself implies you are better at it than the average professional. And just as with stocks, on average it is hard to justify the management fees charged by the funds.

But munis have two differences from stocks that, in my opinion,strongly tilt the decision in favor of funds. The first is that the market for municipal bonds is very illiquid. There is a vast number of municipal bond issues out there, from thousands of different issuers, and very few of them will change hands on any given day. Munis are a lot more like used cars than they are stocks. When you buy or sell, you are not buying or selling to another investor but trading with a dealer who makes his living much as a used car dealer would. He buys from people who need to sell and holds the merchandise in inventory until he can find a buyer to whom he can sell at a profit. And part of the way he makes that profit is that he knows a lot more about what the item is worth than the customers he trades with.

The other reason a fund makes even more sense for munis than it does for stocks is the need for diversification. The nature of bonds is that you will almost certainly get a modest return on your investment, unless there is a default in which case you may lose money, possibly everything you invested. So you would naturally want to be quite well diversified, such that a disaster in one issue would not wipe out the modest gains you got from the other bonds. And that probably means a portfolio of at least several dozen different bonds, which gets impractical for the individual investor.

Muni funds come in two major flavors, open-end and closed-end mutual funds. (There are also two flavors of ETF available, but they are a pretty small slice of the muni world, so I’m going to ignore them.)

Open-end funds are what people usually mean by the term “mutual fund.” If you are familiar with the mechanics of buying and selling stock mutual funds you will have no problem with how muni mutual funds work. About the only difference is that muni funds typically distribute income (interest) monthly. You can find muni open-end mutual funds in the usual places, offered by all the large mutual fund companies. For example, and this is merely chosen as example, there is the Fidelity Tax Free Bond Fund (FTABX) which currently yields 3.60%. You can buy or sell all you want of FTABX every day at the established NAV.

Within muni mutual funds there are two sub-types, single state and national. A single state fund, as the name implies, invests only in the bonds of a particular state. For example, and again this isn’t even remotely a recommendation, there is the Fidelity Massachusetts Municipal Income Fund (FDMMX) currently yielding 3.27%. Single state funds are attractive to investors who live in that state because income from the fund is tax free both at the federal and state level. So even though 3.27% is lower than 3.60%, here in Boston it works out to be a slightly better deal because state tax would be due on the 3.60% but is not on the 3.27%.

And then there are closed end funds. Closed end funds are somewhat archaic as an investment vehicle. They were the original form of mutual fund, popularized in the early years of the 20th Century. A closed end fund is essentially a corporation whose only function is to own financial assets, in this case municipal bonds. Stock in the corporation, that is, shares in the fund, trade on the stock exchange all day long just like any other stock. (And like the comparatively new ETF, which is a variation on the closed end form.)

There are two particularly meaningful differences between closed and open end muni funds. The first is that a closed end fund, being in many ways an ordinary company, can borrow money. Many muni closed end funds are leveraged, meaning that the fund has borrowed money to increase its investment in munis. The result is that the investor gets a higher tax free yield, with higher risk. Although certainly not a free lunch, that increased return is often attractive.

The other big difference is that closed end funds do not necessarily trade at the NAV, the fair value of the underlying bonds. Open end funds by definition only trade at the NAV. At the end of each day the accountants work out what a share is worth and you can buy or sell at that number. Closed end funds, on the other hand, trade on the open market like the stocks that they are, so although it makes sense that they should go for some approximation of their underlying value, the price is actually determined by the market.

In practical terms, this often means that closed end funds trade at a discount to NAV. Sometimes, these discounts can be significant. For example, the Putnam Municipal Opportunities Trust (PMO) has an underlying NAV of $11.85 per share, but closed yesterday at $11.41, a discount of 3.7%. With that discount, and the leverage the fund uses, PMO is currently yielding 6.31% tax free. (Again, nothing even remotely like a recommendation is intended here. I chose the fund randomly.)

Besides the risk involved, the downside on closed end funds is relative illiquidity. They are much more liquid than individual muni bonds, but you cannot simply buy or sell all you want as you can with open end funds. Yesterday PMO traded a grand total of 58,800 shares on the NYSE. That means that a wise person would only trade a few thousand shares in either direction per day, so depending on how much money you were investing, you might have to be very patient on the way in and out.

Of course, even at higher tax rates, 6.31% is not all that exciting given the risk involved. It is probably modestly better than the taxable equivalent, but by a fairly ho-hum margin. At lower tax rates it is not better at all. And that is the basic nature of munis. If you are paying the highest tax rates they are often a small and dull improvement over taxable bonds. For everybody else, they are not worth it.

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