Now that we’ve seen how municipal bonds compare to other investment vehicles, let’s take a closer look at the finances behind them. Understanding the tax implications of muni bonds is a critical step in deciding whether they’re a good investment for you, and learning to navigate the ratings system can raise your awareness of the risks so that you can sleep better at night.
How Bond Finances Work
When you purchase a bond, you’ll be advised of its coupon rate, which is the amount of interest you’ll earn each year based on the bond’s face value. If you buy a bond with a $10,000 face value and a 5% coupon rate, you can expect $500 a year in interest ($10,000 x 5% = $500). Interest payments to bondholders are typically made two times each year ($10,000 x 5% = $500 / 2 = $250).
Some people use the terms “coupon rate” and “yield” synonymously, but in reality, they’re only the same when the bond is worth its original face value. Another way to think of it is that the coupon rate is the rate of return when the bonds were first issued, whereas the yield is the rate of return based on the current price of the bond.
As we already learned, market conditions can cause a bond’s face value to decline. Using our example, let’s say our $10,000 bond drops in price to be worth only $5,000 at face. In this case, its current yield will be 10%, but the coupon rate will remain at 5%, and, assuming the issuer makes payments as scheduled, you’ll still wind up with $500 in annual interest payments.
Muni Bonds and Taxes
You can make money from muni bonds in two ways:
- Collecting interest payments throughout the life of the bond
- Selling the bond for a higher price than what you initially paid and profiting on the face value alone
The first scenario is appealing from a tax perspective because the interest earned on municipal bonds is exempt from federal income taxes, and if you purchase bonds issued by the state in which you reside, the interest may be exempt from state and local taxes as well. Additionally, the interest earned from muni bonds issued by U.S. territories like Puerto Rico, The Virgin Islands, and Guam are also exempt at both the federal and state level. (Tax laws on the state and federal level are constantly being changed so this should not be taken as tax advice. There are many tax professionals that will be able to address your specific tax situation and you should consult with a tax professional before making any decisions based on taxation.)
While tax-exempt interest may be appealing from an investment perspective, it’s important to remember that other investment options that tend to offer higher interest rates, such as corporate bonds, may realize greater returns or be better suited to your personal investment strategy than municipal bonds. When you are deciding if a corporate bond or municipal bond best suits your investment strategy, it’s a good idea to calculate what’s known as the tax-equivalent yield to determine whether taxable corporate bonds or tax-exempt muni bonds are a better overall suitability. There are several online calculators that can help you crunch the numbers.
While it’s a good idea to compare tax-related scenarios on muni versus corporate bond interest rates, remember that any income generated from selling municipal bonds at a premium is subject to capital gains taxes. Similarly, muni bonds that are purchased at a discount for less than face value will be subject to capital gains taxes upon redemption. The tax benefits associated with muni bonds apply only to interest, not principal.
Bond Credit Ratings
Default risk is perhaps the single greatest consideration to purchasing muni bonds. One of the best ways to minimize this risk is to get a clear picture of the issuer’s financial status, and this is where credit ratings come into play.
A credit rating is essentially a measure of an issuer’s likelihood and financial ability to repay its debts. There are three major rating agencies used to evaluate creditworthiness:
- Standard & Poor’s (S&P)
These agencies consider many factors including cash flow, assets, and expenses when assigning ratings.
S&P and Fitch use the same ratings scale, which is as follows:
- AAA: Extremely likely to meet financial commitments
- AA: Very strong likelihood of meeting financial commitments
- A: Strong likelihood of meeting financial commitments, but somewhat susceptible to adverse economic conditions
- BBB: Likely to meet financial commitments, but more susceptible to adverse economic conditions
- BBB: Lowest investment grade
- BB+: Highest speculative grade
- BB: Less vulnerable in the near-term but facing significant ongoing uncertainties
- B: More vulnerable to ongoing uncertainties but currently capable of meeting financial commitments
- CCC: Vulnerable and dependent on favorable business, financial, and economic conditions to meet financial commitments
- CC: Highly vulnerable
- C: Even more highly vulnerable
- D: In default
Moody’s uses a slightly different scale:
- Aaa: Highest quality investments with minimal credit risk
- Aa: High-quality investments with very low credit risk
- A: Reasonably high-quality investments with low credit risk
- Baa: Investments subject to moderate credit risk
- Ba: Investments subject to substantial credit risk
- B: Investments subject to high credit risk
- Caa: Issuers are in poor standing and investments are subject to very high credit risk
- Ca: Issuers are likely in, or very near, default, though the chance to recover interest or principal still exists
- C: Issuers are in default, with little prospect for recovery of principal or interest
Moody’s adds numeric modifiers to ratings Aa through Caa:
- “1” means that the issuer falls on the higher, more favorable end of its category
- “2” means it falls in the middle
- “3” means it falls on the lowest end of its respective rating category
In other words, a bond rated Baa1 by Moody’s has a higher rating than a bond rated Baa3. Bonds rated below BBB- by S&P or Fitch, or Baa3 by Moody’s, are often referred to as junk bonds. They typically offer higher yields than bonds with higher ratings but carry a greater risk of default.
A Smart Investment?
The potential tax benefits and often-respectable yields can make muni bonds an appealing investment choice for some investors, and understanding how credit ratings work can help you assess the underlying risk of default. In our next section, we’ll talk more about why municipal bonds default and review some red flags to look out for.