The municipal bond market has had a good year. Not usually a portfolio standout, munis have rallied alongside the rest of the bond market and are currently offered at yields that are historically low. These securities, however, have an important place in a diversified investment portfolio and continue to offer value to investors. The key is tax-exemption. Income tax levels are low and will go nowhere but up. The Bush Administration’s federal tax cuts are due to expire in a year and mounting federal deficits as well as a low rate of household income only increase the tax burden that will need to be filled.
Municipal securities offer investors a chance to earn current income without increasing their tax liability. Since state and local governments are struggling with high deficit levels and will face a high degree of financial strain in the coming years, staying diversified is the key to investment success. Municipal defaults, while rare, will likely increase in 2010.
An important metric to understand when assessing relative value for munis is the “taxable-equivalent yield.” This is going to vary by investor and is based on your personal income-tax bracket. The taxable-equivalent-yield or TEY is what you want to compare to treasury or corporate bond investments in the same credit and maturity bracket to understand your relative earning potential. The formula is simple – just take a muni fund’s current yield and divide it by 1 minus your tax rate.
TEY = (muni yield) / (1-t)
The average no-load intermediate muni fund has a current yield of around 3.63%. Therefore, if you are an investor in the top 35% tax-bracket, your equivalent TEY is 5.58%. This means that you would need to earn the equivalent of 5.58% on a taxable bond to net the same level of income on a post-tax basis.
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Disclosure: At the time of writing, Adrienne Penake has no position in the securities mentioned. Be advised that positions may change without further notice
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