Where are the Munis?

February 2, 2004

While each of our model portfolios are carefully constructed to deliver high risk adjusted returns, we can’t design them to fit everyone’s individual needs perfectly.

We discussed many of the issues you need to think about when managing your portfolio in a past newsletter. One more area of interest by subscribers as tax season approaches is municipal bond funds. We don’t have any of them in our model portfolios. Why not, and should you own some?

Since everybody hates taxes (ever hear a politician run on a platform of raising taxes across the board?) municipal bond funds have appeal because they seem like a great tax dodge. And unlike sending empty boxes to New Hampshire to avoid paying New York City sales taxes like Tyco ex chief Dennis Kozlowski did, avoiding taxes with munis is 100% legal.

Municipal bonds are bonds issued by state governments to finance a variety to spending initiatives they can’t afford and probably shouldn’t be doing anyway. The income investors receive owning these state bonds is generally exempt from federal taxes – a perk the federal government gives the states to help them raise money cheaply. If the bonds are issued from your own state of residency, they are likely exempt from state taxes as well.

If you own municipal bonds issued from states other then your state of residency, you will generally have to pay state income tax, but not federal tax.

To figure out what the after tax yield is on a municipal bond you have to know your marginal tax rate, including your state tax rate if you are buying single state municipal bonds.

Your marginal tax bracket is the tax rate on your last dollar of income. The federal tax system has graduated tax brackets, which means you pay less tax on your first dollars of income then your last. While you tax bracket may be 28%, in fact your weighted tax rate is probably closer to 25% or less as you are paying a 10% rate on your first $7,000 in income, 15% on the next $21,400 and so on. What’s relevant with municipal bonds is your tax bracket on that last dollar of income.

Let’s say you are in the 28% tax bracket. Currently the Vanguard Long-Term Tax Exempt fund has a tax free (federally) yield of about 3.27%. To figure out how much you would have to earn on a regular bond fund to achieve a 3.27% after tax yield, divide the tax-free yield by (1- tax rate). In this case, 3.27% / (1-.28) = 4.54%. Can you get 4.54% easily? Maybe. The Vanguard Long Term Treasury fund currently yields 4.5% taxable.

There are two problems with this comparison: even though the yields are similar after tax, the Long Term Treasury fund currently has slightly longer maturity bonds, which means it should yield more as you are taking on more risk. However, federal government bonds are safer then any state bonds. States run into financial hot water and their bond ratings can sink, the federal government can raise taxes to pay for just about any mess it gets itself into. Plus states don’t control the money supply and interest rates like the government does. State bonds are usually quite safe but are sometime more risky, especially in the so called high yield muni bond funds that invest in less liquid and more speculative bond offerings tied to specific revenue projects.

Because of such differences it can be difficult to compare after tax yields apples to apples as you have to find an alternative taxable bond fund with a similar risk profile and duration (measure of the bonds susceptibility to price changes with interest rate movements, generally related to average maturity of the bonds). However, bonds are usually correctly priced by the market, which means you almost don’t have to worry because the after tax yield on a municipal bond as it should be very close to a taxable bond, adjusting for risk and duration. If it wasn’t investors would flock to one and avoid the other until prices equalized. 

The only thing you really have to worry about is determining if you are a good candidate for a municipal bond fund. Just because you don’t like paying taxes does not automatically qualify you for municipal bonds.

The top federal tax bracket is 33%. To people in that tax bracket, municipal bonds offer the greatest after tax yield. Because people in this high tax bracket will buy municipal bonds until the after tax yield is comparable to taxable corporates and government bonds, there is parity to this bracket. 

An investor in the 15% tax bracket will also not have to pay federal taxes on their muni bond interest, however, their after tax yield will always be better in a taxable bond of equivalent risk and duration. Why? Because the bond can’t be a good deal for the 33% tax bracket individual and the 15% tax bracket individual at the same time – the bonds price was set by the former to achieve near parity with taxable bonds. For investors in the next highest tax bracket there can be some benefits to owning municipal bonds, but the benefits over taxable bonds falls fast. By the third highest bracket (25%) there is generally no benefit at all.

Investors following our model portfolios can generally ignore municipal bond funds. However, investors in the top 1 or 2 tax brackets (33% and 28% federal) who live in high tax rate states like New York, California, and Minnesota can consider single state municipal bond funds that own bonds from their state. High tax bracket individuals from states with lower state taxes can consider a diversified multi-state muni bond fund.

If you do consider municipal bond funds, you must only go with a low fee choice as the fund’s fees come out of your tax free yield. With rates so low, it's totally inexcusable to pay even 1% a year in fees to buy bonds yielding just 3% or so, as is the case with tax free bonds today. DON’T GIVE 1/3 of your yield to a fund company! Vanguard has good low fee municipal bond funds, as does Fidelity with their Spartan line of low fee (but high minimum) funds. 

As state bonds can be risky in certain cases, the low .25% per year or less in fees these funds charge is worth the diversification, to say nothing of the better execution and commission rates these fund mangers get compared to buying bonds directly.

Note that only the income from the interest payments on the bonds is tax exempt. If you realize capital gains on the bonds, (usually the result of interest rates falling while you own older, higher coupon bonds, you will have to pay capital gains taxes on the profits (only if you sell).

Obviously, owning municipal bonds inside of an IRA or other tax deferred investment account makes no sense at all; in fact you will be penalized as all money removed from such a plan upon retirement will be taxed as ordinary income – including what should have been tax-free interest.

There is a chance of making a small windfall gain on a municipal bond fund if the government has to undue the recent tax cuts. This could happen if we get a new administration or if our current one has trouble lowering the deficit without a tax increase.

As we mentioned above, municipal bond prices are set by high tax bracket individuals. If the high tax bracket goes from 33% to 39%, muni bonds instantly offer that much more of an advantage over taxable bonds and will likely rise in price to offset this added value. This is not a massive price change, but certainly measurable. 

In fact the bush tax cut was terrible for states. Lowered tax brackets means higher costs of borrowing for states as the after tax return on muni bonds fell with the tax cut – the states had to offer more in interest to entice buyers away from taxable investments. Lowering taxes on dividends didn’t help maters much either.


As long-time subscribers to the MAXadvisor newsletter know, we publish our monthly editorial in the middle of each month. At the same time we update our commentary for each of the model portfolios as well as the performance for the month that ended two weeks previous. 

In an effort to improve the quality of your subscription, we are introducing a new update and alert schedule that will affect content, data, and trading.

Starting this month we will release our monthly editorial article on the first day of each month. We will continue to update the performance of the funds in the model portfolios and comment on each portfolio at the middle of the month. We will be alerting you by email when these updates and articles are available to view.

The MAXadvisor newsletter also contains our outlook for each major stock fund category as well as our favorite funds in each category. While we only update outlooks when we have adjustments to make to the list of our favorite funds or our outlook for a category changes, we will now alert you via email when there are changes to a category. 

In order to make following our model portfolios as easy as possible, we normally trade our model portfolios on the last business day of each month. The MAXadvisor newsletter is not about active trading. Our model portfolios generally have very low turnover. We will now alert you by email approximately one week before the end of each month if we intend to trade on the last business day of that month. We will also have information about the trading in the relevant model portfolios “changes” page. If circumstances require us to make a trade before the end of the month, we will alert subscribers by email when the decision to trade is made.

To summarize, the calendar for MAXadvisor subscribers will now look like this:

1st of the month: Monthly fund investing article

Middle of the month: Performance and commentary updates to model portfolios

Third Week of Month: Upcoming trades (If any)

Emails will then typically go out on the 1st and 15th, and in months we trade, one week before the end of the month. Category outlook updates notices will go out with these regular emails.

In addition to notifying you by email of these updates, we've added a new page that lists all the recent alerts and updates.