Municipal bonds and the tax exemption

- [Instructor] Let's take a closer look at municipal bonds to see if they might be right for you. Investors in municipal securities are exposed to the same risks affecting corporate bonds, but they also have one more risk that we could call tax risk. There are basically two types of tax risk for muni bonds. The first element of risk is that the individual federal income tax rate will be reduced. If tax rates are reduced, that makes the muni tax exemption less valuable. Think about it for a minute. If the tax rate is 0% at the federal level, well then the fact that you're exempt from taxes doesn't matter. You don't pay anything anyway. If the tax rate is 99%, meaning you pay 99 cents of every dollar that you earn to the government, well then that tax exemption is extremely valuable. So the lower the federal income tax rate is, the less valuable that muni tax exemption is. The second element in tax risk is if the IRS turns around and decides that municipal bonds actually are taxable. Now, the US Supreme Court had a landmark 1898 decision, which said municipal bonds are not taxable. However, that doesn't mean that that decision couldn't be challenged or reviewed in the future by the IRS and then ultimately by the Supreme Court. So it would likely take an act of Congress followed by a Supreme Court decision to overturn the tax exemption. But it is something that comes up once every few decades on municipal bond investors' radar. Now, how do we measure the value of that tax exemption? Well, the answer is we use this formula. So essentially, we can determine the equivalent taxable yield based on the formula you see here. The equivalent taxable yield on a corporate bond is equal to our tax exempt yield divided by one minus the marginal tax rate. So if for example, the tax exempt yield on a municipal bond is 6% and the marginal tax rate is 50%, well then we have a taxable equivalent yield of 6% divided by one minus 0.5 or 6% divided by 0.5, which is 12%. You'd be indifferent. You'd earn the same amount of money after taxes, whether you had a corporate bond paying 12% or a municipal bond paying six. The two are equally attractive on an after-tax basis. Now, the other thing you need to know about municipal bonds is that despite having these attractive tax characteristics, there's not that many individual investors that benefit a lot from this because it's really only attractive when you're at kind of the upper end of the income spectrum. So municipal securities markets have relatively low liquidity. And then following their initial sale, municipal securities just don't trade all that often, and that's because there's a limited number of buyers and a huge number of muni issuers. In fact, fun fact, for your next date or dinner party. There are more municipal bonds out there than any other form of security. There's over 80,000 municipal bond issuers and over 800,000 municipal bonds. Well, you're going to be the life of the party at your next date or dinner party, aren't you? (chuckles) So the point is that in 2017, about 99% of the municipal bonds out there didn't trade on any given day. And those bonds that do trade, the number of trades is very low. There's only about 14 trades that occur for a particular bond if it trades in that first 60 days after issuance. Newly issued municipal bonds are the most actively traded. What this means for investors is, if you're going to buy a municipal bond, you need to plan on this being a buy-and-hold investment rather than a trading investment. Almost all municipal bonds do trade in the first month after issuance, but by the time we get to the second month, it's only about 15% of them trading. And then after that, it's even less. That secondary market, where investors trade bonds between one another, for municipal bonds, it's just not very transparent. We do have pricing information about completed trades that comes from the MSRB, the Municipal Securities Ruling Board, but that's about all we have. Now, that Municipal Securities Ruling Board, they are the muni bond regulatory group, and they've been putting out this information since 1995. But we don't have any information about what prices market participants might be willing to pay. So we can look at stocks, and we see bids and asks, that tell us what we would pay for a stock if we want to buy it, or what we'd receive if we want to sell it. We don't have anything like bids or asks for municipal bonds, in many cases. So we tend to have a lack of transparency in pricing to the degree that we have it in equities and other investments. The other thing to be aware of with municipal bonds is that pricing is higher for smaller sized retail trades. If you're an individual, you're going to pay more for a bond than a larger institution does. A retail investor, somebody like you or me, we might pay a thousand dollars for the same bond that an institutional investor pays $970 for. This lack of price transparency also makes it difficult for customers, especially individuals like you or I, to assess the value of our municipal bonds and then any prices that are offered by municipal bond dealers. So we don't know if we're getting a fair price or not. So you want to be cautious about municipal bonds when you're buying them. This should be an investment that you buy and then hold rather than an investment you're trying to trade. Now you're better prepared to evaluate municipal bonds as an option for your portfolio, and you are a little bit more interesting the next time you have a date or dinner party, right?