Why You Should Buy Municipal Bonds

When it comes to fixed income investments, municipal bonds stand out as an attractive option for many investors.  These bonds, issued by local governments and municipalities, can offer significant tax advantages. Municipal bonds can also offer financial stability due to their low risk of default; according to a published report from Vanguard, on average the cumulative default rates for investment-grade municipal bonds total 0.09% over ten-year periods; this compares favorably to the 2.17% default rate for the global corporate bond markets of 12/31/21. In this blog, LCM Capital Management will explore the advantages of municipal bonds and why they are a favored fixed income vehicle of the firm.

Tax-Free Interest Income

One of the most significant advantages of investing in municipal bonds is the tax-free interest income they generate.  Who amongst us believes tax rates are heading lower any time soon?  The interest earned from most municipal bonds is exempt from federal income tax.  In some cases, interest on municipal bonds may also be exempt from state and local income taxes if you reside in the state or municipality that issued the bond.  This tax advantage allows investors to keep a larger portion of their investment returns, making municipal bonds an attractive option for individuals in higher tax brackets.

Alternative Minimum Tax (AMT) Relief

The Alternative Minimum Tax (AMT) is a parallel tax system which was originally designed to ensure that high-income taxpayers pay their “fair share” of taxes.  However, with the changes in our tax code over the years, AMT can bite even lower income earners.  Thankfully certain investments, including most municipal bonds, are exempt from the AMT calculation.  This means that investors who are subject to the AMT can enjoy tax-free interest income from municipal bonds without triggering additional tax liabilities.  The AMT relief further enhances the tax advantages of municipal bonds and provides flexibility for investors to manage their tax obligations.

Capital Gains Tax Benefits

While municipal bonds are primarily known for their tax advantages related to interest income, they can also offer tax benefits regarding capital gains. If an investor sells a municipal bond at a profit, the capital gains generated from that sale are typically exempt from federal income tax. This capital gains tax exemption can be particularly valuable for long-term investors looking to maximize their after-tax returns and minimize their tax obligations. We would caution you though, if you are selling a bond for a profit, it means that interest rates have dropped since buying the bond, (bonds prices typically move inversely to interest rates) which means if you are wanting to lock in your gain and buy another bond, expect the new bond to be paying you less than the one you are looking to sell. 

Social Impact and Buyer Beware

Beyond the tax advantages, municipal bonds offer investors the opportunity to support local communities and contribute to the development of essential public projects such as schools, hospitals, roads, and utilities. By investing in these individual bonds, investors can indirectly support initiatives that positively impact their communities while still enjoying the financial benefits associated with them. Make sure however that you understand the financial condition of the state or municipality that is issuing the bonds since not all bonds are created equal. This is where a quality financial advisor can be a significant advantage since they often have the resources available to them to form a judgment regarding the ability of the issuer to make the required payments on the bonds.    Avoid using municipal bond mutual funds as these funds separate you from control of tax advantages, investment choices and can introduce uncontrolled taxable capital gains.

Conclusion

Individual municipal bonds provide investors with an array of advantages, with tax benefits being a key highlight. The tax-free interest income, state and local tax exemptions, AMT relief, and capital gains tax benefits make these bonds an attractive choice for tax-conscious investors. Additionally, investing in municipal bonds allows individuals to align their financial goals with social impact by supporting local infrastructure projects. It's important to consult with a financial advisor or tax professional to fully understand the tax implications and benefits associated with municipal bonds. By investing with these tax advantages, investors can optimize their investment returns while contributing to the improvement of their communities.