After Taxes, Munis Make Sense

In today's chart we're going to examine municipal bonds and whether they make sense for investors today.

The key advantage of municipal bonds is that the interest they pay is federally tax-free, and if you invest in a bond issued by the state you live in, it is likely state-tax free.

In the chart we calculate a tax-equivalent yield ratio to compare municipal bond yields to U.S. Treasury yields. The tax-equivalent yield is the pretax yield a taxable bond would need to pay to equal the municipal bond yield. This calculation depends on a person's tax bracket, so in the chart we calculated it for people in the highest tax-bracket and those with only a $100,000 income.

To calculate the ratio, we take the tax-equivalent yield for someone in the highest tax bracket, which is 2.98%, divided by the current Treasury bond yield of 1.81%. This gives you a ratio of 1.65, which means that by investing in municipal bonds, an investor earns 65% more income on an aftertax basis than investing in Treasury bonds.

This is obviously attractive for the wealthy, but municipal bond investing still makes sense for people of more modest means, because for someone with $100,000 income they still earn income that is 32% higher than comparable Treasuries.

Municipal bonds have had a bad reputation since the financial crisis. The very public defaults of Detroit and San Bernardino, and the continuing crisis in Puerto Rico, have given the sector a bad name. Despite these issues, default rates for the entire asset class have remained low. The bad press has created opportunities for investors willing to look through the headlines.

Investors in the 25% tax bracket or higher should consider replacing their government bonds with municipal bonds in their portfolios.