July 21, 2025 • 27 mins
When to Buy Municipal Bonds – Municipal bonds are debt securities issued by governmental
entities to finance public projects like schools, highways, or water systems. For investors seeking
stability and tax advantages, municipal bonds can be an appealing component of a diversified
portfolio. However, as with any investment, they are rarely a good choice as their suitability
depends on individual circumstances, risk tolerance, and broader market conditions. Senior
Portfolio Manager Brian Regan joins Chris Boyd and Jeff Perry to review if and when municipal
bonds are right for your portfolio. #bonds #municipalbonds #investing #financialplan
#diversification
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Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
(00:00):
Welcome to Something More with Chris Boyd.
Chris Boyd is a certified financial planner, practitioner,
and senior vice president and financial advisor at
Wealth Enhancement Group, one of the nation's largest
registered investment advisors.
We call it Something More because we'd like
to talk not only about those important dollar
and cents issues, but also the quality of
life issues that make the money matters matter.
(00:22):
Here he is, your fulfillment facilitator, your partner
in prosperity, advising clients on Cape Cod and
across the country.
Here's your host, Jay Christopher Boyd.
Welcome to Something More with Chris Boyd.
I'm here with Jeff Perry and Brian Regan,
all of us of the AMR team at
Wealth Enhancement.
(00:43):
And glad to have you joining us today.
We're going to talk a little bit about
municipal bonds.
Jeff, we get these questions a lot, don't
we?
We do, yeah.
Clients will often think about why not use
tax-free bonds?
Why am I paying taxes?
Boy, I've got a lot of taxes as
it is.
Maybe I'd be better off avoiding some of
(01:04):
the tax in my non-IRA accounts, that
kind of thing.
Well, we've seen them in IRA accounts before.
That's true.
And actually- I've put them in IRA
accounts before.
During extreme circumstances, but that was like during
the pandemic or something extreme like that.
(01:26):
But I think that's what we want to
talk about today.
Why or why not use municipal bonds?
And to help us navigate that, we've got
Brian Regan, our team senior portfolio manager, talking
with us today.
So Brian, let's start by explaining which kinds
(01:47):
of bonds pay what kind of tax.
So when it comes to, for example, and
maybe we'll even back up further, what's a
bond?
A bond is when I lend my money
to a corporation or a government with the
expectation that I will get it back at
some point at the end of the term
(02:09):
of that bond.
And I get consideration for that.
There's actually more types than that, because sometimes
I get my principal back over time and
sometimes at the end and so forth.
But let's just think of it simply similar
to the way I might think of a
certificate of deposit with the bank.
I decide, do I want a one year
(02:30):
term or a five year term or longer
in the case of a bond?
I pick the term I want.
I lend my money.
I'm going to get back my principal at
the end.
And I get some consideration for that.
And the things that might factor into how
much consideration I get might be how much
risk am I taking?
(02:52):
Is this a corporation that is very stable
or one that's not so much?
Is this a government entity that's very stable
or one not so much?
Is this a bond that is tied to
a specific occasion, a specific project, or is
(03:14):
this tied to the taxing authority of a
municipality or a state or whatever it might
be?
So all of these factors will impact how
the bond is priced, the interest rate I
might get.
Similarly, how long I commit my money will
(03:35):
play a role in this.
And typically as an investor, I think, well,
if I'm going to commit my money longer,
I want more consideration for that.
I want to get a little better deal.
And that's when we start talking about the
yield curve, that's looking at how much more
consideration do I get or not because of
expectations of what might happen with interest rates
(03:56):
over time.
Well, we're not going to focus on the
yield curve today, but we are going to
talk about some of these other considerations.
So that's maybe what a bond is, essentially.
Generally, we think of bonds as being more
predictable and less volatile, a little bit less
risk, depending on the credit quality of what
we're buying.
(04:18):
And when it comes to the taxation of
bonds, if I have a corporate bond, the
interest that it generates, the income that it
generates, all of that is subject to taxation,
whether it's on the federal level or on
the state level.
(04:38):
And if I sell it before it's maturity
and it is worth more or less than
what I bought it for, well, then I
might entertain whether I have a capital gain
or a capital loss.
But if I just buy it at inception,
wait till it matures, I've put in my
amount, I get that amount back, and the
(04:59):
interest is the tax I'm going to deal
with.
Now, in the case of a treasury, which
is a bond issued by the federal government,
that has some tax benefit that is not
taxed by the state.
It is tax-free on the state level
for income tax.
(05:20):
However, it is potentially, and is generally, taxed
by the federal government.
Whereas a municipal bond, something issued by a
state or municipality entity, can be tax-free
on both levels, but it avoids the federal
(05:42):
tax.
And if it is from my state, I
get taxed in for income, it can avoid
that tax as well.
However, I live in Massachusetts.
If I bought a New York municipal bond,
I wouldn't pay federal tax, but I might
still have to pay Massachusetts income tax on
(06:05):
that bond.
So that's sort of the basic tax considerations.
You guys might have things to add because
I hopefully covered the basics of that.
But what do we want to add to
that?
Oh, well, I would just add that I
think it almost never makes sense for most
people to buy municipal bonds.
(06:25):
It's a very rare occasion where I think
it makes sense.
And why do I think that?
Well, just on the face of it, if
you were to compare, on average, seven-year
municipal bond to a seven-year taxable bond,
the yield will be significantly lower.
The yield will be significantly lower because the
market's taking into account the respective tax savings.
(06:48):
So one way or another, you are going
to essentially pay that tax.
You can get the muni bond and get
a lower rate, or you could buy the
taxable bond and get a higher rate and
pay taxes.
Now, the formula to determine whether or not
it's worth it for you is what we
(07:11):
call the tax equivalent yield.
The yield on the municipal bond in question
divided by one minus the tax rate.
The textbook version will tell you that you
should use a marginal tax rate.
I don't think there's anything wrong with doing
the effective tax rate, and there's a few
reasons why I think that.
The effective tax rate's actually what you pay.
And unless you're committing a lot of capital
(07:35):
towards the municipal bonds, it's likely that the
marginal rate won't highly impact what you're going
to pay in the following year.
Secondly, if you do end up paying a
capital gain, so let's say that the stars
align and it makes a lot of sense
for you to buy municipal bonds, and then
the market corrects, and you want to take
(07:56):
a capital gain, well, you're going to end
up paying taxes on that capital gain.
And I think that using the effective tax
rate rather than the marginal tax rate might
take into account the effects of that possible
capital gain that you might take in the
future.
So I think you can use either one.
(08:17):
The marginal tax rate is a much more
conservative way to do it because it's a
higher rate.
The effective tax rate's probably going to be
a lower rate.
So let's stop for a second, Brian, because
I think you threw a lot there to
start with.
Let's just go back for a minute.
You're getting into the differences between a marginal
(08:38):
rate and an effective rate.
Let's explain what that means to our listeners
in case they're not clear about what that
is.
So if you have an income of a
certain amount, whether you're married or filing jointly,
right, there's thresholds.
You land in different tax brackets based on
that.
So when you talk about the marginal rate,
(09:01):
it's the, oh, I have this much income,
I'm landing in the top tax bracket of
that amount of, let's say it's 24%, something
like that.
Well, not all of that income is paying
24% because you've gone through other tax
rates before that last dollar of income is
(09:23):
getting taxed at that 24% rate, let's
say.
I'm making up the number in this case.
But you've also paid some 10%, some 15%,
and so on, 22%.
So your effective tax rate might be lower.
Oh, it was 20%.
I'm, again, making up numbers.
(09:44):
But whatever that figure is, you had a
lower effective rate.
And so, Brian, you're arguing that when one
tries to do this calculation, which we're going
to come back and explain a little, because
you went through that very quickly, I want
to make sure people understand how that works.
But when you try to do this calculation
of how do I compare a taxable versus
(10:07):
a tax-free environment, which rate should I
use?
My top tier, that marginal tax rate?
Or should I use that effective tax rate
with the average, if you will, of the
rates I've used?
And your argument was to use the effective
rate, Brian?
Yeah.
I mean, I'm at a step with the
(10:28):
textbook definition.
The textbook definition would tell you to use
the marginal tax rate.
I think that gets people into municipal bonds
that likely shouldn't be in municipal bonds.
Because like I said, if the stars align
and you're in a municipal bond, and then
the market cracks, you might end up taking
a capital gain anyways.
So for these reasons, unless you're committing a
(10:48):
huge swath of your capital towards municipal bonds,
I think it makes just as much sense
to use the effective tax rate, which will
give you a lower tax equivalent yield and
probably keep you out of municipal bonds more
often.
But if you wanted to use a marginal
tax rate, I wouldn't fight you on it.
I think either one you use, the math
(11:11):
almost never works out to make municipal bonds
a better deal.
So let's elaborate on that a little bit.
Yeah.
Before you, let's explain the math a little
bit more closely.
Give us an example of this formula in
use.
And let's say, what's a yield I might
(11:34):
get from a tax-free municipal bond?
3%?
What's a realistic number?
Let's just say, hypothetically, you live in California.
And in this case, and you make a
lot of money, let's say you make a
million dollars a year.
And I'm guessing these tax rates, but I
(11:54):
think they're probably fairly accurate, right?
Let's say that your marginal tax rate between
federal and state is close to 50%.
And let's say that since you live in
California, municipal bond rates are probably lower because
this is one of those states that you
would want to buy a municipal bond in
more likely than not.
Let's say the yield is 2%.
(12:16):
So you take 2% divided by 1
minus, let's just use the marginal tax rate
to be conservative, 50%.
What number do you get?
You get a tax equivalent yield of 4%.
I can go buy a treasury today for
the same length of time and get 4
.5%. So I would be giving up a
(12:39):
half a percentage point or 50 basis points
worth of value by buying a municipal bond
rather than buying the taxable bond and paying
my taxes.
So I have the sense of satisfaction that
I didn't have to pay that tax, but
in reality, I gave up some interest even
(13:01):
after tax that I would have still made
a little bit more by paying the tax
and having the treasury in your example, where
I end up with a little bit better
outcome than avoiding the tax.
So that's not to say we haven't run
(13:21):
into people that would be willing to take
that deal because they just were sick of
paying the taxes.
Or in that example, they pay a lot
of taxes at a million dollars of income.
But as a math equation, it doesn't work
in this example.
Now, let's think about it more commonly.
Most people don't make a million dollars a
(13:42):
year.
So let's say someone's in the 22 or
the 24% tax bracket.
And a lot of our clients are in
Massachusetts.
Unless you do make a million dollars a
year, then you're paying 9% state income
tax rate.
But most people would pay 5% state
(14:04):
income tax rate.
So let's say, you know, we're all in
we're under 30%, you know, 27, or something
like that, in our tax rate.
Right.
So that equation, if I, what's the rate
in Massachusetts, for example, Brian, for a muni
(14:25):
bond fund that one might typically get or
a municipal bond example?
Am I in the ballpark saying 3%?
Three and a quarter, something like that?
I think three would be generous.
I don't have it in front of me
right now.
So let's just use that as an example.
Let's say 3% at a 23%
(14:46):
tax rate.
Is that what you said?
I said, you're 22 in the federal five
on the state, you know, so that's 27,
right?
22 and 27.
So that gives us 73% we're gonna
divide.
You would get 4.1% under that
scenario, which still doesn't, you know, make the
(15:08):
treasury less appealing.
You're still better served.
Here's the added caveat to this, right?
Even in a state like California or state
like Massachusetts, where the credit, the credits are
usually pretty good, you know, but they're not,
they're not guaranteed by any stretch of the
imagination, especially when it comes to, you know,
like specifics.
(15:28):
Sometimes you can buy a hospital, which is
considered a municipal bond.
And, you know, we've seen here in Massachusetts,
some hospitals go belly up, right?
So these are not riskless like a treasury.
So you would have- Would you elaborate
on the idea so that just what you're
talking about is the difference between a general
(15:50):
obligation, right?
Something that's tied to a particular entity versus
something that's tied to the taxing authority.
Talk about these distinctions.
Sure.
So a general obligation bond is tied to
the taxing authority.
So that means if you were to buy
a bond in the state of California, the
(16:10):
revenues from the state of California, the taxing
authority from the state of California is on
the hook for paying the bond.
There's also something called a revenue bond.
Now a revenue bond is tied to a
specific project.
So let's say, you know, you're building-
Talking about the hospital example, or they're going
to- Yeah, you're building a hospital or
toll booth or something like that.
(16:31):
The revenues of those projects need to support
the interest payments and- It's specifically tied
to that limited revenue capacity.
Yeah.
So there is credit risk in some of
these bonds.
So comparing it to a treasury, even though
the math did not work against the treasury,
(16:53):
is not an appropriate comparison.
You have to compare it to, let's say,
an A-rated bond, right?
Which will get a spread over treasury.
So you're really looking at something, you're comparing
it to maybe five and a quarter, five
and a half percent, which- It's maybe
even a harder equation to overcome and say,
oh, there's value and benefit in getting that
tax-free rate.
(17:14):
Because for a credit equivalent, you really should
be looking at something that pays even more
in the corporate or in the taxable setting
than what that tax-free bond will yield
you in comparison, in an after-tax equivalent
comparison.
So let's say that hypothetically that the math
(17:37):
works out, which for very few people it
does, for very few occasions it does.
But let's say you live in New York
or California, you make a ton of money.
Good for you.
Congratulations.
I'm happy for you.
And this equation works out for you.
What do you do?
(17:58):
Well, or what are the problems?
Well, if you're in California, you really only
want to own California municipal bonds.
If you're in New York, you really only
want to use New York municipal bonds.
So what does- Because of what I
mentioned earlier, just because you own a municipal
bond, if it's not your state that you're
taxed in, it still could be taxed.
(18:19):
Right.
So you don't necessarily just want to buy
an ETF of diversified bonds.
So diversification becomes a real problem.
It becomes a real challenge.
And why do I say California and New
York?
Those are typically the highest taxed states.
They're typically the states where this math might
make sense.
Yeah.
Remember in New York, you can be taxed
not only on state, but municipality level as
(18:41):
well.
There could be income tax implications.
So yeah, it works more effectively.
Yeah.
And the more money you make, the more
that marginal tax rate makes sense and the
less the effective tax rate makes sense.
So there's more opportunity for this to make
sense for you individually.
But going back to my point, it's really
(19:03):
hard to get diversified.
Now, here's some other things that people should
know.
Only the interest is tax deductible.
So what does that mean?
You have to buy bonds at a premium.
So most municipal bonds are priced at a
premium.
So what does that mean?
If at the end of maturity, you get
(19:24):
a hundred dollars, most of the bonds are
priced over a hundred dollars.
Sorry, Brian.
If I'm not buying the bond at inception,
but I go out and buy it on
the marketplace after it's already been issued from
someone else who bought it previously, that's when
I'm facing this issue of premium that you're
(19:45):
talking about.
Yeah.
If you can buy a premium bond, that's
actually a good thing because then all your
interest expense will be shielded from tax.
But if you have to buy a bond
at a discount, so rates go up since
it's been issued and you buy the bond
at a discount, that amortization towards par is
(20:06):
going to be taxable because it's going to
be considered a realized gain when it matures.
So you might not get the stated yield
to maturity all tax-free in that circumstance.
So that math that I mentioned, that tax
equivalent yield does not work if there are
bonds that are trading at a discount in
the portfolio.
So you got to buy premium bonds.
You got to buy bonds in the state.
(20:28):
It helps if you buy new issued bonds,
you're going to have some credit risks, specifically
from those revenue-oriented type bonds rather than
the general obligation bonds.
Finally, the duration of these bonds, the maturities
are typically longer.
When you buy a fund for sure, you
(20:49):
tend to buy a longer duration within a
fund than you might choose to otherwise.
So what does that mean?
There's some inherent interest rate risks, more inherent
interest rate risks than there would otherwise be.
So you put all this together and are
municipal bonds for you?
The answer is probably not.
(21:09):
I know that people like them and I
always say that they're great for the issuer.
They're great for the state.
They're great for the municipality.
They may not necessarily be great for you
as an investor.
So a lot of complexities to consider.
There's a lot of variations.
It's not purely the interest rate consideration, but
(21:31):
who's the title we gave this episode is
when to buy municipal bonds.
Let's kind of sum that up.
It's when you're in a very high tax
bracket, when you're in a very high tax
state, these might be the circumstances where the
math can work, but you have to be
(21:51):
very selective.
And it's often the case that you're still
better off to buy taxable bonds because you
can net more even after paying taxes.
And you might have less duration risk.
You might have less capital gain consideration in
this, or it might give some of these
things that you're not anticipating can muddy the
(22:12):
waters.
Yeah.
Going back to the effective tax rate versus
marginal tax rate.
If your effective tax rate is approaching your
marginal tax rate, you might want to look
into it.
I mean, you make enough money where the
math will more often make sense.
And that's why I say that we ignore
the effective tax rate and the marginal tax
rates, the textbook reason.
But I think it's fair to consider the
(22:36):
effective tax rate, given that it's so common
for people to inappropriately get into these types
of instruments.
So yeah, sometimes it sounds better than it
actually is when it comes to municipal bonds.
Who doesn't like the idea of avoiding tax?
But I think most people would say, all
(22:56):
right, I can save you taxes, but you'll
make less money net even after tax.
Is that what you want to do?
Most people would say no.
So anything else to add?
What do you think, Jeff, Brian?
I think we hit it.
That's less frequently desirable for people.
(23:18):
What were you going to say, Jeff?
I was just going to say the analysis
that we're doing today is based upon the
current treasury rates, right?
So if you saw significant changes in treasuries,
that would change the analysis, but have to
be quite a change to make it meaningful
for most people.
If there's a change in treasuries, it's probably
a change in the municipal bond yield curve
(23:38):
too.
I mean, there are opportunities.
I'm not saying it never happens.
I'm just saying it's rare.
Um, Chris, if you have a second, I
mean, I'd love to revisit that.
Yeah, the 2020 or whatever.
Yeah, that was a great experience.
Uh, so that was kind of, as we
all know, it was a wild time though.
Yeah.
Right.
And what I called that was an occluded
(23:59):
event, right?
Like people were just running the doors.
I need cash.
I need cash now.
I don't care what price.
And when people do that, the markets get
really distorted and there's oftentimes really good opportunities
in really strange places.
This was a time when we actually put
municipal bonds across all accounts, regardless of its
tax status, because we weren't in it for
(24:21):
the tax equivalent yield.
We were in it for the likely capital
gains that was going to come from a
wild mispricing.
So, um, at that time you bought treasuries
and sometimes we were using high yield in
place of equities as a place, as a
way to take less risk to get, uh,
(24:41):
tax equity, you know, to get essentially a
risk equivalent of stock returns without having to
take as much risk in the process.
Yeah.
I mean, that's how it ended up.
Right.
So, um, if you guys remember back then
the federal reserve, Jerome Powell, uh, came out
and said, the federal reserve will basically backstop
on municipal bonds at 5%.
(25:02):
We'll refinance any municipal bond at 5%.
So that essentially put a 4 on all
bonds at a 5% yield and the
bonds were trading well above 5%.
Um, it was an incredible opportunity.
So there was an arbitrage there that closed
within two months, um, where, you know, we
could take that excess duration, um, put it
(25:25):
in people's portfolios and know that it would
make a ton of sense for these bonds
to fall, you know, at least 1%, but
likely more than that, um, as they came
into equilibrium with treasuries.
And I think we ended up making like
a 19% return on it within a
few months.
Um, so anomalies happen.
Um, I'm happy to take advantage of them
(25:46):
when they do, uh, but they're few and
far between and usually in some kind of
a unique situation in this case, the pandemic.
Yeah.
So, um, but your point, Jeff was, um,
I think, uh, one that's worth mentioning that
notion that things change, right.
And it's, uh, worth, uh, you know, revisiting
(26:06):
when there are different circumstances.
As it stands today, by and large, we
would encourage people to think more in terms
of taxable bonds because of the net math.
Um, but like you said, you know, it's
not static.
You got to check it out from time
to time.
Hey, this was a good conversation guys.
Thanks so much.
And for our listeners, um, you know, listen,
(26:28):
if you're thinking about your portfolio and maybe
you have municipal bonds in the mix and
wondering, is it the right thing?
Maybe it's something you've wanted to think about
and you want to get a little bit
more into the weeds.
We can look at things in the particulars
of your financial plan and your portfolio and
see if we can help you navigate what's
(26:49):
best for your circumstances.
If you need a little hand with that,
don't hesitate to reach out to us.
In the meantime, thanks for being with us
until next time, everybody keeps driving for something
more.
Thank you for listening to something more with
Chris Boyd, call us for help, whether it's
for financial planning or portfolio management, insurance concerns,
(27:10):
or those quality of life issues that make
the money matters matter.
Whatever's on your mind, visit us at something
more with chrisboyd.com or call us at
866-771-8901, or send us your questions
to amr-info at wealthenhancement.com.
(27:30):
You're listening to something more with Chris Boyd,
financial talk show wealth enhancement, advisory services, and
Jay Christopher Boyd provide investment advice on an
individual basis to clients.
Only proper advice depends on a complete analysis
of all facts and circumstances.
The information given on this program is general
financial comments and cannot be relied upon as
pertaining to your specific situation.
Wealth Enhancement Group cannot guarantee that using the
information from this show will generate profits or
(27:51):
ensure freedom from loss.
Listeners should consult their own financial advisors or
conduct their own due diligence before making any
financial decisions.
Welcome to Something More with Chris Boyd.
Chris Boyd is a certified financial planner, practitioner,
and senior vice president and financial advisor at
Wealth Enhancement Group, one of the nation's largest
registered investment advisors.
We call it Something More because we'd like
to talk not only about those important dollar
and cents issues, but also the quality of
life issues that make the money matters matter.
(00:22):
Here he is, your fulfillment facilitator, your partner
in prosperity, advising clients on Cape Cod and
across the country.
Here's your host, Jay Christopher Boyd.
Welcome to Something More with Chris Boyd.
I'm here with Jeff Perry and Brian Regan,
all of us of the AMR team at
Wealth Enhancement.
(00:43):
And glad to have you joining us today.
We're going to talk a little bit about
municipal bonds.
Jeff, we get these questions a lot, don't
we?
We do, yeah.
Clients will often think about why not use
tax-free bonds?
Why am I paying taxes?
Boy, I've got a lot of taxes as
it is.
Maybe I'd be better off avoiding some of
(01:04):
the tax in my non-IRA accounts, that
kind of thing.
Well, we've seen them in IRA accounts before.
That's true.
And actually- I've put them in IRA
accounts before.
During extreme circumstances, but that was like during
the pandemic or something extreme like that.
(01:26):
But I think that's what we want to
talk about today.
Why or why not use municipal bonds?
And to help us navigate that, we've got
Brian Regan, our team senior portfolio manager, talking
with us today.
So Brian, let's start by explaining which kinds
(01:47):
of bonds pay what kind of tax.
So when it comes to, for example, and
maybe we'll even back up further, what's a
bond?
A bond is when I lend my money
to a corporation or a government with the
expectation that I will get it back at
some point at the end of the term
(02:09):
of that bond.
And I get consideration for that.
There's actually more types than that, because sometimes
I get my principal back over time and
sometimes at the end and so forth.
But let's just think of it simply similar
to the way I might think of a
certificate of deposit with the bank.
I decide, do I want a one year
(02:30):
term or a five year term or longer
in the case of a bond?
I pick the term I want.
I lend my money.
I'm going to get back my principal at
the end.
And I get some consideration for that.
And the things that might factor into how
much consideration I get might be how much
risk am I taking?
(02:52):
Is this a corporation that is very stable
or one that's not so much?
Is this a government entity that's very stable
or one not so much?
Is this a bond that is tied to
a specific occasion, a specific project, or is
(03:14):
this tied to the taxing authority of a
municipality or a state or whatever it might
be?
So all of these factors will impact how
the bond is priced, the interest rate I
might get.
Similarly, how long I commit my money will
(03:35):
play a role in this.
And typically as an investor, I think, well,
if I'm going to commit my money longer,
I want more consideration for that.
I want to get a little better deal.
And that's when we start talking about the
yield curve, that's looking at how much more
consideration do I get or not because of
expectations of what might happen with interest rates
(03:56):
over time.
Well, we're not going to focus on the
yield curve today, but we are going to
talk about some of these other considerations.
So that's maybe what a bond is, essentially.
Generally, we think of bonds as being more
predictable and less volatile, a little bit less
risk, depending on the credit quality of what
we're buying.
(04:18):
And when it comes to the taxation of
bonds, if I have a corporate bond, the
interest that it generates, the income that it
generates, all of that is subject to taxation,
whether it's on the federal level or on
the state level.
(04:38):
And if I sell it before it's maturity
and it is worth more or less than
what I bought it for, well, then I
might entertain whether I have a capital gain
or a capital loss.
But if I just buy it at inception,
wait till it matures, I've put in my
amount, I get that amount back, and the
(04:59):
interest is the tax I'm going to deal
with.
Now, in the case of a treasury, which
is a bond issued by the federal government,
that has some tax benefit that is not
taxed by the state.
It is tax-free on the state level
for income tax.
(05:20):
However, it is potentially, and is generally, taxed
by the federal government.
Whereas a municipal bond, something issued by a
state or municipality entity, can be tax-free
on both levels, but it avoids the federal
(05:42):
tax.
And if it is from my state, I
get taxed in for income, it can avoid
that tax as well.
However, I live in Massachusetts.
If I bought a New York municipal bond,
I wouldn't pay federal tax, but I might
still have to pay Massachusetts income tax on
(06:05):
that bond.
So that's sort of the basic tax considerations.
You guys might have things to add because
I hopefully covered the basics of that.
But what do we want to add to
that?
Oh, well, I would just add that I
think it almost never makes sense for most
people to buy municipal bonds.
(06:25):
It's a very rare occasion where I think
it makes sense.
And why do I think that?
Well, just on the face of it, if
you were to compare, on average, seven-year
municipal bond to a seven-year taxable bond,
the yield will be significantly lower.
The yield will be significantly lower because the
market's taking into account the respective tax savings.
(06:48):
So one way or another, you are going
to essentially pay that tax.
You can get the muni bond and get
a lower rate, or you could buy the
taxable bond and get a higher rate and
pay taxes.
Now, the formula to determine whether or not
it's worth it for you is what we
(07:11):
call the tax equivalent yield.
The yield on the municipal bond in question
divided by one minus the tax rate.
The textbook version will tell you that you
should use a marginal tax rate.
I don't think there's anything wrong with doing
the effective tax rate, and there's a few
reasons why I think that.
The effective tax rate's actually what you pay.
And unless you're committing a lot of capital
(07:35):
towards the municipal bonds, it's likely that the
marginal rate won't highly impact what you're going
to pay in the following year.
Secondly, if you do end up paying a
capital gain, so let's say that the stars
align and it makes a lot of sense
for you to buy municipal bonds, and then
the market corrects, and you want to take
(07:56):
a capital gain, well, you're going to end
up paying taxes on that capital gain.
And I think that using the effective tax
rate rather than the marginal tax rate might
take into account the effects of that possible
capital gain that you might take in the
future.
So I think you can use either one.
(08:17):
The marginal tax rate is a much more
conservative way to do it because it's a
higher rate.
The effective tax rate's probably going to be
a lower rate.
So let's stop for a second, Brian, because
I think you threw a lot there to
start with.
Let's just go back for a minute.
You're getting into the differences between a marginal
(08:38):
rate and an effective rate.
Let's explain what that means to our listeners
in case they're not clear about what that
is.
So if you have an income of a
certain amount, whether you're married or filing jointly,
right, there's thresholds.
You land in different tax brackets based on
that.
So when you talk about the marginal rate,
(09:01):
it's the, oh, I have this much income,
I'm landing in the top tax bracket of
that amount of, let's say it's 24%, something
like that.
Well, not all of that income is paying
24% because you've gone through other tax
rates before that last dollar of income is
(09:23):
getting taxed at that 24% rate, let's
say.
I'm making up the number in this case.
But you've also paid some 10%, some 15%,
and so on, 22%.
So your effective tax rate might be lower.
Oh, it was 20%.
I'm, again, making up numbers.
(09:44):
But whatever that figure is, you had a
lower effective rate.
And so, Brian, you're arguing that when one
tries to do this calculation, which we're going
to come back and explain a little, because
you went through that very quickly, I want
to make sure people understand how that works.
But when you try to do this calculation
of how do I compare a taxable versus
(10:07):
a tax-free environment, which rate should I
use?
My top tier, that marginal tax rate?
Or should I use that effective tax rate
with the average, if you will, of the
rates I've used?
And your argument was to use the effective
rate, Brian?
Yeah.
I mean, I'm at a step with the
(10:28):
textbook definition.
The textbook definition would tell you to use
the marginal tax rate.
I think that gets people into municipal bonds
that likely shouldn't be in municipal bonds.
Because like I said, if the stars align
and you're in a municipal bond, and then
the market cracks, you might end up taking
a capital gain anyways.
So for these reasons, unless you're committing a
(10:48):
huge swath of your capital towards municipal bonds,
I think it makes just as much sense
to use the effective tax rate, which will
give you a lower tax equivalent yield and
probably keep you out of municipal bonds more
often.
But if you wanted to use a marginal
tax rate, I wouldn't fight you on it.
I think either one you use, the math
(11:11):
almost never works out to make municipal bonds
a better deal.
So let's elaborate on that a little bit.
Yeah.
Before you, let's explain the math a little
bit more closely.
Give us an example of this formula in
use.
And let's say, what's a yield I might
(11:34):
get from a tax-free municipal bond?
3%?
What's a realistic number?
Let's just say, hypothetically, you live in California.
And in this case, and you make a
lot of money, let's say you make a
million dollars a year.
And I'm guessing these tax rates, but I
(11:54):
think they're probably fairly accurate, right?
Let's say that your marginal tax rate between
federal and state is close to 50%.
And let's say that since you live in
California, municipal bond rates are probably lower because
this is one of those states that you
would want to buy a municipal bond in
more likely than not.
Let's say the yield is 2%.
(12:16):
So you take 2% divided by 1
minus, let's just use the marginal tax rate
to be conservative, 50%.
What number do you get?
You get a tax equivalent yield of 4%.
I can go buy a treasury today for
the same length of time and get 4
.5%. So I would be giving up a
(12:39):
half a percentage point or 50 basis points
worth of value by buying a municipal bond
rather than buying the taxable bond and paying
my taxes.
So I have the sense of satisfaction that
I didn't have to pay that tax, but
in reality, I gave up some interest even
(13:01):
after tax that I would have still made
a little bit more by paying the tax
and having the treasury in your example, where
I end up with a little bit better
outcome than avoiding the tax.
So that's not to say we haven't run
(13:21):
into people that would be willing to take
that deal because they just were sick of
paying the taxes.
Or in that example, they pay a lot
of taxes at a million dollars of income.
But as a math equation, it doesn't work
in this example.
Now, let's think about it more commonly.
Most people don't make a million dollars a
(13:42):
year.
So let's say someone's in the 22 or
the 24% tax bracket.
And a lot of our clients are in
Massachusetts.
Unless you do make a million dollars a
year, then you're paying 9% state income
tax rate.
But most people would pay 5% state
(14:04):
income tax rate.
So let's say, you know, we're all in
we're under 30%, you know, 27, or something
like that, in our tax rate.
Right.
So that equation, if I, what's the rate
in Massachusetts, for example, Brian, for a muni
(14:25):
bond fund that one might typically get or
a municipal bond example?
Am I in the ballpark saying 3%?
Three and a quarter, something like that?
I think three would be generous.
I don't have it in front of me
right now.
So let's just use that as an example.
Let's say 3% at a 23%
(14:46):
tax rate.
Is that what you said?
I said, you're 22 in the federal five
on the state, you know, so that's 27,
right?
22 and 27.
So that gives us 73% we're gonna
divide.
You would get 4.1% under that
scenario, which still doesn't, you know, make the
(15:08):
treasury less appealing.
You're still better served.
Here's the added caveat to this, right?
Even in a state like California or state
like Massachusetts, where the credit, the credits are
usually pretty good, you know, but they're not,
they're not guaranteed by any stretch of the
imagination, especially when it comes to, you know,
like specifics.
(15:28):
Sometimes you can buy a hospital, which is
considered a municipal bond.
And, you know, we've seen here in Massachusetts,
some hospitals go belly up, right?
So these are not riskless like a treasury.
So you would have- Would you elaborate
on the idea so that just what you're
talking about is the difference between a general
(15:50):
obligation, right?
Something that's tied to a particular entity versus
something that's tied to the taxing authority.
Talk about these distinctions.
Sure.
So a general obligation bond is tied to
the taxing authority.
So that means if you were to buy
a bond in the state of California, the
(16:10):
revenues from the state of California, the taxing
authority from the state of California is on
the hook for paying the bond.
There's also something called a revenue bond.
Now a revenue bond is tied to a
specific project.
So let's say, you know, you're building-
Talking about the hospital example, or they're going
to- Yeah, you're building a hospital or
toll booth or something like that.
(16:31):
The revenues of those projects need to support
the interest payments and- It's specifically tied
to that limited revenue capacity.
Yeah.
So there is credit risk in some of
these bonds.
So comparing it to a treasury, even though
the math did not work against the treasury,
(16:53):
is not an appropriate comparison.
You have to compare it to, let's say,
an A-rated bond, right?
Which will get a spread over treasury.
So you're really looking at something, you're comparing
it to maybe five and a quarter, five
and a half percent, which- It's maybe
even a harder equation to overcome and say,
oh, there's value and benefit in getting that
tax-free rate.
(17:14):
Because for a credit equivalent, you really should
be looking at something that pays even more
in the corporate or in the taxable setting
than what that tax-free bond will yield
you in comparison, in an after-tax equivalent
comparison.
So let's say that hypothetically that the math
(17:37):
works out, which for very few people it
does, for very few occasions it does.
But let's say you live in New York
or California, you make a ton of money.
Good for you.
Congratulations.
I'm happy for you.
And this equation works out for you.
What do you do?
(17:58):
Well, or what are the problems?
Well, if you're in California, you really only
want to own California municipal bonds.
If you're in New York, you really only
want to use New York municipal bonds.
So what does- Because of what I
mentioned earlier, just because you own a municipal
bond, if it's not your state that you're
taxed in, it still could be taxed.
(18:19):
Right.
So you don't necessarily just want to buy
an ETF of diversified bonds.
So diversification becomes a real problem.
It becomes a real challenge.
And why do I say California and New
York?
Those are typically the highest taxed states.
They're typically the states where this math might
make sense.
Yeah.
Remember in New York, you can be taxed
not only on state, but municipality level as
(18:41):
well.
There could be income tax implications.
So yeah, it works more effectively.
Yeah.
And the more money you make, the more
that marginal tax rate makes sense and the
less the effective tax rate makes sense.
So there's more opportunity for this to make
sense for you individually.
But going back to my point, it's really
(19:03):
hard to get diversified.
Now, here's some other things that people should
know.
Only the interest is tax deductible.
So what does that mean?
You have to buy bonds at a premium.
So most municipal bonds are priced at a
premium.
So what does that mean?
If at the end of maturity, you get
(19:24):
a hundred dollars, most of the bonds are
priced over a hundred dollars.
Sorry, Brian.
If I'm not buying the bond at inception,
but I go out and buy it on
the marketplace after it's already been issued from
someone else who bought it previously, that's when
I'm facing this issue of premium that you're
(19:45):
talking about.
Yeah.
If you can buy a premium bond, that's
actually a good thing because then all your
interest expense will be shielded from tax.
But if you have to buy a bond
at a discount, so rates go up since
it's been issued and you buy the bond
at a discount, that amortization towards par is
(20:06):
going to be taxable because it's going to
be considered a realized gain when it matures.
So you might not get the stated yield
to maturity all tax-free in that circumstance.
So that math that I mentioned, that tax
equivalent yield does not work if there are
bonds that are trading at a discount in
the portfolio.
So you got to buy premium bonds.
You got to buy bonds in the state.
(20:28):
It helps if you buy new issued bonds,
you're going to have some credit risks, specifically
from those revenue-oriented type bonds rather than
the general obligation bonds.
Finally, the duration of these bonds, the maturities
are typically longer.
When you buy a fund for sure, you
(20:49):
tend to buy a longer duration within a
fund than you might choose to otherwise.
So what does that mean?
There's some inherent interest rate risks, more inherent
interest rate risks than there would otherwise be.
So you put all this together and are
municipal bonds for you?
The answer is probably not.
(21:09):
I know that people like them and I
always say that they're great for the issuer.
They're great for the state.
They're great for the municipality.
They may not necessarily be great for you
as an investor.
So a lot of complexities to consider.
There's a lot of variations.
It's not purely the interest rate consideration, but
(21:31):
who's the title we gave this episode is
when to buy municipal bonds.
Let's kind of sum that up.
It's when you're in a very high tax
bracket, when you're in a very high tax
state, these might be the circumstances where the
math can work, but you have to be
(21:51):
very selective.
And it's often the case that you're still
better off to buy taxable bonds because you
can net more even after paying taxes.
And you might have less duration risk.
You might have less capital gain consideration in
this, or it might give some of these
things that you're not anticipating can muddy the
(22:12):
waters.
Yeah.
Going back to the effective tax rate versus
marginal tax rate.
If your effective tax rate is approaching your
marginal tax rate, you might want to look
into it.
I mean, you make enough money where the
math will more often make sense.
And that's why I say that we ignore
the effective tax rate and the marginal tax
rates, the textbook reason.
But I think it's fair to consider the
(22:36):
effective tax rate, given that it's so common
for people to inappropriately get into these types
of instruments.
So yeah, sometimes it sounds better than it
actually is when it comes to municipal bonds.
Who doesn't like the idea of avoiding tax?
But I think most people would say, all
(22:56):
right, I can save you taxes, but you'll
make less money net even after tax.
Is that what you want to do?
Most people would say no.
So anything else to add?
What do you think, Jeff, Brian?
I think we hit it.
That's less frequently desirable for people.
(23:18):
What were you going to say, Jeff?
I was just going to say the analysis
that we're doing today is based upon the
current treasury rates, right?
So if you saw significant changes in treasuries,
that would change the analysis, but have to
be quite a change to make it meaningful
for most people.
If there's a change in treasuries, it's probably
a change in the municipal bond yield curve
(23:38):
too.
I mean, there are opportunities.
I'm not saying it never happens.
I'm just saying it's rare.
Um, Chris, if you have a second, I
mean, I'd love to revisit that.
Yeah, the 2020 or whatever.
Yeah, that was a great experience.
Uh, so that was kind of, as we
all know, it was a wild time though.
Yeah.
Right.
And what I called that was an occluded
(23:59):
event, right?
Like people were just running the doors.
I need cash.
I need cash now.
I don't care what price.
And when people do that, the markets get
really distorted and there's oftentimes really good opportunities
in really strange places.
This was a time when we actually put
municipal bonds across all accounts, regardless of its
tax status, because we weren't in it for
(24:21):
the tax equivalent yield.
We were in it for the likely capital
gains that was going to come from a
wild mispricing.
So, um, at that time you bought treasuries
and sometimes we were using high yield in
place of equities as a place, as a
way to take less risk to get, uh,
(24:41):
tax equity, you know, to get essentially a
risk equivalent of stock returns without having to
take as much risk in the process.
Yeah.
I mean, that's how it ended up.
Right.
So, um, if you guys remember back then
the federal reserve, Jerome Powell, uh, came out
and said, the federal reserve will basically backstop
on municipal bonds at 5%.
(25:02):
We'll refinance any municipal bond at 5%.
So that essentially put a 4 on all
bonds at a 5% yield and the
bonds were trading well above 5%.
Um, it was an incredible opportunity.
So there was an arbitrage there that closed
within two months, um, where, you know, we
could take that excess duration, um, put it
(25:25):
in people's portfolios and know that it would
make a ton of sense for these bonds
to fall, you know, at least 1%, but
likely more than that, um, as they came
into equilibrium with treasuries.
And I think we ended up making like
a 19% return on it within a
few months.
Um, so anomalies happen.
Um, I'm happy to take advantage of them
(25:46):
when they do, uh, but they're few and
far between and usually in some kind of
a unique situation in this case, the pandemic.
Yeah.
So, um, but your point, Jeff was, um,
I think, uh, one that's worth mentioning that
notion that things change, right.
And it's, uh, worth, uh, you know, revisiting
(26:06):
when there are different circumstances.
As it stands today, by and large, we
would encourage people to think more in terms
of taxable bonds because of the net math.
Um, but like you said, you know, it's
not static.
You got to check it out from time
to time.
Hey, this was a good conversation guys.
Thanks so much.
And for our listeners, um, you know, listen,
(26:28):
if you're thinking about your portfolio and maybe
you have municipal bonds in the mix and
wondering, is it the right thing?
Maybe it's something you've wanted to think about
and you want to get a little bit
more into the weeds.
We can look at things in the particulars
of your financial plan and your portfolio and
see if we can help you navigate what's
(26:49):
best for your circumstances.
If you need a little hand with that,
don't hesitate to reach out to us.
In the meantime, thanks for being with us
until next time, everybody keeps driving for something
more.
Thank you for listening to something more with
Chris Boyd, call us for help, whether it's
for financial planning or portfolio management, insurance concerns,
(27:10):
or those quality of life issues that make
the money matters matter.
Whatever's on your mind, visit us at something
more with chrisboyd.com or call us at
866-771-8901, or send us your questions
to amr-info at wealthenhancement.com.
(27:30):
You're listening to something more with Chris Boyd,
financial talk show wealth enhancement, advisory services, and
Jay Christopher Boyd provide investment advice on an
individual basis to clients.
Only proper advice depends on a complete analysis
of all facts and circumstances.
The information given on this program is general
financial comments and cannot be relied upon as
pertaining to your specific situation.
Wealth Enhancement Group cannot guarantee that using the
information from this show will generate profits or
(27:51):
ensure freedom from loss.
Listeners should consult their own financial advisors or
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