Municipal bonds offer fantastic yields, especially in these four high-tax states

By Philip van Doorn

You can earn high yields on municipal bonds right now, while avoiding risk in the stock market.

If you are an investor, assumptions built up during decades of low bond yields now have to go out the window. Interest rates are now high enough that you can get compelling returns on municipal bonds, if you take tax advantages into account.

This assumes of course that you are paying high-enough income taxes that avoiding them is worthwhile. Early in October we looked at exchange-traded funds that invest in municipal bonds paying interest that is exempt from federal income taxes. We also dug into two high-tax states, because if you (or your ETF) hold tax exempt bonds issued within your state, the interest is also exempt from state and local income taxes.

Read: How to tell if it is worth avoiding taxes with a municipal-bond ETF

But bond funds also have fluctuating share prices. If you hold an individual bond until maturity (or until it is called, as explained below), you don't have to worry about how much its market value fluctuates. (Bond prices fall as interest rates rise and vice versa.) You know the price you will pay, so your only risk is that of default, which is rare for municipal bonds. And that risk can be mitigated by sticking with investment-grade-rated securities.

According to Lewis Altfest, CEO of Altfest Personal Wealth Management in New York, municipal bonds "are very attractive right now."

"The spreads have narrowed between Treasury bonds and munis," he said during an interview with MarketWatch.

Dan Genter CEO of RNC Genter Capital Management in Los Angeles, also talked about the dynamic bond market in a separate interview with MarketWatch: "It is pretty amazing. In 17 months you went back to where you were 17 years ago. It is nice to have some income and have some yield -- to be in a situation where you're making money."

Altfest and Genter provided examples of investment-grade bonds issued in four high-tax states: California, New York, New Jersey and Illinois.

But before looking at the examples within those states, we have to lay out some facts and definitions:

U.S. Treasury bills, notes and bonds are issued by the federal government. They pay interest that is exempt from state and local taxes, but the interest is fully taxed on the federal level.Municipal bonds are issued by states and local governments in the U.S. For most, the interest paid is exempt from federal income taxes, and for residents of the state in which they are issued, the interest may also be exempt from any city income taxes. You need to find out about both tax exemptions -- some taxable or partially taxable municipal bonds have competitive yields.General obligation bonds are backed by the taxing authority of a state or municipality. Revenue bonds are municipal bonds backed by revenue generated by the project the bonds support, such as a toll bridge or an airport.CUSIP number -- a nine-character identification assigned to a security. It is commonly used for bonds but can be useful to identify equities if an issuer has several classes of common or preferred stocks.Maturity date and call date -- The maturity date is when the bond will be repaid at face value. Many bonds also feature call dates. An issuer of a bond may call the bond (redeem it at face value) on or after the call date. Price -- This is a bond's price relative to its face value. If a bond is trading at its face value, we say it is trading at 100, or par. If it is trading at 1% above or below its market value, we say it is trading at 101 or 99.Coupon -- This is the interest rate a bond issuer pays based on the bond's face value.YTM -- This is a bond's yield to maturity, which is an annualized figure that factors in its current market price, the coupon and the capital gain or loss the investor would take if they were to hold the bond to maturity, because of the premium or discounted price they would pay.YTC -- This is a bond's yield to call, which is similar to the yield to maturity, except that it incorporates the call date rather than the maturity date.Duration -- This is a risk measure used for bond portfolios or bond funds, that takes bonds' maturity dates into account. Typically, the longer the maturity, the more a bond's market value will fluctuate as interest rates move. For example, the SPDR Nuveen Municipal Bond ETF TFI has a duration of 7.0 years, according to FactSet. This means investors can expect the share price to fall by 7% if interest rates rise by 1% and vice versa.

You may also run into the term "yield to worst," which is used for some bond indexes, to show the lower of a portfolio's weighted yield to maturity of yield to call. Unless interest rates have risen since a bond was issued, you should expect it to be called as soon as the issuer can do so.

YTM and YTC are very useful when calculating expected returns, because they provide annualized yields that factor-in an investor's expected capital loss if they pay a premium to the face value or expected capital gain if they buy they bond at a discount to the face value.

Comparing yields by factoring-in taxes

Financial advisers and investors typically compare tax exempt and taxable yields by calculating a taxable-equivalent yield for a municipal bond.

If you are subject to the federal Alternative Minimum Tax (AMT) you need to look closely at individual municipal bonds before you buy them. This article doesn't encompass the AMT.

Let us say for example that you live in a state such as Texas that doesn't have a state income tax. This will simplify our comparison of a municipal bond issued in any state with a U.S. Treasury security.

Here are the federal income-tax brackets for 2023:

           Graduated tax rate          Income over (individual)  Income over (filing jointly) 
                  12%                                   $11,000                       $22,000 
                  22%                                   $44,725                       $89,450 
                  24%                                   $95,375                      $190,750 
                  32%                                  $182,100                      $364,200 
                  35%                                  $231,250                      $462,500 
                  37%                                  $578,125                      $693,750 
                                                             Source: Internal Revenue Service 

These are the adjusted taxable income levels -- that is, after your tax deductions.

If you are wondering about the additional 3.8% net investment income tax required under the Affordable Care Act of 2010, Genter had a useful reminder: Tax-exempt interest isn't included in calculations for this tax, so we don't need to consider the ACA in this article.

Here's a very simple taxable equivalent calculation making use of the highest-yielding bond among the examples provided by Altfest and Genter:

The market yield on 10-year U.S. Treasury bond notes BX:TMUBMUSD10Y was 4.88% early on Monday.Genter provided an example of a municipal bond backed by the revenue of Chicago Midway International Airport. This bond doesn't have a call date. Its coupon is a fixed 5% and it matures in 2030. The CUSIP is 167562RU3. It is priced at 101.953. Its yield to maturity is 4.63%, according to Bloomberg. The interest paid is exempt from federal income taxes but is subject to state income taxes.

If the investor is in the 24% federal income-tax bracket, we can calculate the taxable-equivalent yield for the Chicago Midway bond by dividing its YTM of 4.63% by 1 less the tax rate. So 4.63% divided by 0.76 gives us a taxable-equivalent yield of 6.09%.

On a yield basis, this investor is better off with the municipal bond. And if they investor is in the 37% federal tax bracket, we divide the bond's YTM of 4.63% by 0.63 for a taxable-equivalent yield of 7.35%.

Altfest said taxable equivalent yields on munis above 7% are "close to equity-type returns," which seem "good, especially now."

Genter pointed out that for some investors, it might be easier if they do the reverse -- apply the tax rate to the taxable yield. In other words, the after-tax yield for the 10-year Treasury yield is 4.88% multiplied by 0.76 for the investor in the 24% tax bracket, or 3.71%. For the investor in the 37% tax bracket, 4.88% multiplied by .63 is 3.07%, which is a pretty lousy yield in this environment.

Now let us dig into four states, with examples of bonds exempt from federal income taxes and from state and local taxes for residents of the states in which they are issued.

Four high-tax states

Keep in mind that if you live in a state with no income tax, you have quite an advantage, being able to look for the best yields on municipal bonds issued in any state.

Altfest said that for his clients, he sticks with bonds that have high credit ratings. "We like AA or higher," he said, referring to ratings by Standard & Poor's. Generally a rating of BBB- or higher from S&P or Fitch Ratings is considered to be investment-grade. This would be the equivalent of a Baa3 rating from Moody's. Fidelity breaks down the credit agencies' ratings hierarchy.

Altfest added: "To us, a double-A in munis is much more attractive than a double-A in corporates." This is because a municipal issuer who is facing financial difficulty can take steps that a corporate borrower cannot take, including increasing taxes. He also said that municipal credit quality is looking "good across the board right now."

Genter said he and his staff were focused on A-rated municipal bonds as well as AA, but he also said that "you don't get caught by surprise" with defaults in the municipal market because "you are getting a lot of visibility into any deteriorating conditions." Some of the bonds rated below AA are still considered AA because they are insured through Build America Mutual, in what is known as a "BAM wrap."

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10-30-23 1326ET

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