Welcome to Something More with Chris Boyd. Chris Boyd is a certified financial planner, practitioner, and senior vice president and financial advisor at Wealth Enhancement Group, one of the nation's largest registered investment advisors. We call it Something More because we'd like to talk not only about those important dollar and cents issues, but also the quality of life issues that make the money matters matter.
Here he is, your fulfillment facilitator, your partner in prosperity, advising clients on Cape Cod and across the country. Here's your host, Jay Christopher Boyd. Welcome to Something More with Chris Boyd. I'm here with Jeff Perry and Brian Regan, all of us of the AMR team at Wealth Enhancement. And glad to have you joining us today. We're going to talk a little bit about municipal bonds. Jeff, we get these questions a lot, don't we? We do, yeah.
Clients will often think about why not use tax-free bonds? Why am I paying taxes? Boy, I've got a lot of taxes as it is. Maybe I'd be better off avoiding some of the tax in my non-IRA accounts, that kind of thing. Well, we've seen them in IRA accounts before. That's true. And actually- I've put them in IRA accounts before. During extreme circumstances, but that was like during the pandemic or something extreme like that. But I think that's what we want to talk about today.
Why or why not use municipal bonds? And to help us navigate that, we've got Brian Regan, our team senior portfolio manager, talking with us today. So Brian, let's start by explaining which kinds of bonds pay what kind of tax. So when it comes to, for example, and maybe we'll even back up further, what's a bond? A bond is when I lend my money to a corporation or a government with the expectation that I will get it back at some point at the end of the term of that bond.
And I get consideration for that. There's actually more types than that, because sometimes I get my principal back over time and sometimes at the end and so forth. But let's just think of it simply similar to the way I might think of a certificate of deposit with the bank. I decide, do I want a one year term or a five year term or longer in the case of a bond? I pick the term I want. I lend my money. I'm going to get back my principal at the end. And I get some consideration for that.
And the things that might factor into how much consideration I get might be how much risk am I taking? Is this a corporation that is very stable or one that's not so much? Is this a government entity that's very stable or one not so much? Is this a bond that is tied to a specific occasion, a specific project, or is this tied to the taxing authority of a municipality or a state or whatever it might be? So all of these factors will impact how the bond is priced, the interest rate I might get.
Similarly, how long I commit my money will play a role in this. And typically as an investor, I think, well, if I'm going to commit my money longer, I want more consideration for that. I want to get a little better deal. And that's when we start talking about the yield curve, that's looking at how much more consideration do I get or not because of expectations of what might happen with interest rates over time.
Well, we're not going to focus on the yield curve today, but we are going to talk about some of these other considerations. So that's maybe what a bond is, essentially. Generally, we think of bonds as being more predictable and less volatile, a little bit less risk, depending on the credit quality of what we're buying.
And when it comes to the taxation of bonds, if I have a corporate bond, the interest that it generates, the income that it generates, all of that is subject to taxation, whether it's on the federal level or on the state level. And if I sell it before it's maturity and it is worth more or less than what I bought it for, well, then I might entertain whether I have a capital gain or a capital loss.
But if I just buy it at inception, wait till it matures, I've put in my amount, I get that amount back, and the interest is the tax I'm going to deal with. Now, in the case of a treasury, which is a bond issued by the federal government, that has some tax benefit that is not taxed by the state. It is tax-free on the state level for income tax. However, it is potentially, and is generally, taxed by the federal government.
Whereas a municipal bond, something issued by a state or municipality entity, can be tax-free on both levels, but it avoids the federal tax. And if it is from my state, I get taxed in for income, it can avoid that tax as well. However, I live in Massachusetts. If I bought a New York municipal bond, I wouldn't pay federal tax, but I might still have to pay Massachusetts income tax on that bond. So that's sort of the basic tax considerations.
You guys might have things to add because I hopefully covered the basics of that. But what do we want to add to that? Oh, well, I would just add that I think it almost never makes sense for most people to buy municipal bonds. It's a very rare occasion where I think it makes sense. And why do I think that? Well, just on the face of it, if you were to compare, on average, seven-year municipal bond to a seven-year taxable bond, the yield will be significantly lower.
The yield will be significantly lower because the market's taking into account the respective tax savings. So one way or another, you are going to essentially pay that tax. You can get the muni bond and get a lower rate, or you could buy the taxable bond and get a higher rate and pay taxes. Now, the formula to determine whether or not it's worth it for you is what we call the tax equivalent yield. The yield on the municipal bond in question divided by one minus the tax rate.
The textbook version will tell you that you should use a marginal tax rate. I don't think there's anything wrong with doing the effective tax rate, and there's a few reasons why I think that. The effective tax rate's actually what you pay. And unless you're committing a lot of capital towards the municipal bonds, it's likely that the marginal rate won't highly impact what you're going to pay in the following year.
Secondly, if you do end up paying a capital gain, so let's say that the stars align and it makes a lot of sense for you to buy municipal bonds, and then the market corrects, and you want to take a capital gain, well, you're going to end up paying taxes on that capital gain. And I think that using the effective tax rate rather than the marginal tax rate might take into account the effects of that possible capital gain that you might take in the future. So I think you can use either one.
The marginal tax rate is a much more conservative way to do it because it's a higher rate. The effective tax rate's probably going to be a lower rate. So let's stop for a second, Brian, because I think you threw a lot there to start with. Let's just go back for a minute. You're getting into the differences between a marginal rate and an effective rate. Let's explain what that means to our listeners in case they're not clear about what that is.
So if you have an income of a certain amount, whether you're married or filing jointly, right, there's thresholds. You land in different tax brackets based on that. So when you talk about the marginal rate, it's the, oh, I have this much income, I'm landing in the top tax bracket of that amount of, let's say it's 24%, something like that.
Well, not all of that income is paying 24% because you've gone through other tax rates before that last dollar of income is getting taxed at that 24% rate, let's say. I'm making up the number in this case. But you've also paid some 10%, some 15%, and so on, 22%. So your effective tax rate might be lower. Oh, it was 20%. I'm, again, making up numbers. But whatever that figure is, you had a lower effective rate.
And so, Brian, you're arguing that when one tries to do this calculation, which we're going to come back and explain a little, because you went through that very quickly, I want to make sure people understand how that works. But when you try to do this calculation of how do I compare a taxable versus a tax-free environment, which rate should I use? My top tier, that marginal tax rate? Or should I use that effective tax rate with the average, if you will, of the rates I've used?
And your argument was to use the effective rate, Brian? Yeah. I mean, I'm at a step with the textbook definition. The textbook definition would tell you to use the marginal tax rate. I think that gets people into municipal bonds that likely shouldn't be in municipal bonds. Because like I said, if the stars align and you're in a municipal bond, and then the market cracks, you might end up taking a capital gain anyways.
So for these reasons, unless you're committing a huge swath of your capital towards municipal bonds, I think it makes just as much sense to use the effective tax rate, which will give you a lower tax equivalent yield and probably keep you out of municipal bonds more often. But if you wanted to use a marginal tax rate, I wouldn't fight you on it. I think either one you use, the math almost never works out to make municipal bonds a better deal. So let's elaborate on that a little bit.
Yeah. Before you, let's explain the math a little bit more closely. Give us an example of this formula in use. And let's say, what's a yield I might get from a tax-free municipal bond? 3%? What's a realistic number? Let's just say, hypothetically, you live in California. And in this case, and you make a lot of money, let's say you make a million dollars a year. And I'm guessing these tax rates, but I think they're probably fairly accurate, right?
Let's say that your marginal tax rate between federal and state is close to 50%. And let's say that since you live in California, municipal bond rates are probably lower because this is one of those states that you would want to buy a municipal bond in more likely than not. Let's say the yield is 2%. So you take 2% divided by 1 minus, let's just use the marginal tax rate to be conservative, 50%. What number do you get? You get a tax equivalent yield of 4%.
I can go buy a treasury today for the same length of time and get 4 .5%. So I would be giving up a half a percentage point or 50 basis points worth of value by buying a municipal bond rather than buying the taxable bond and paying my taxes.
So I have the sense of satisfaction that I didn't have to pay that tax, but in reality, I gave up some interest even after tax that I would have still made a little bit more by paying the tax and having the treasury in your example, where I end up with a little bit better outcome than avoiding the tax. So that's not to say we haven't run into people that would be willing to take that deal because they just were sick of paying the taxes.
Or in that example, they pay a lot of taxes at a million dollars of income. But as a math equation, it doesn't work in this example. Now, let's think about it more commonly. Most people don't make a million dollars a year. So let's say someone's in the 22 or the 24% tax bracket. And a lot of our clients are in Massachusetts. Unless you do make a million dollars a year, then you're paying 9% state income tax rate. But most people would pay 5% state income tax rate.
So let's say, you know, we're all in we're under 30%, you know, 27, or something like that, in our tax rate. Right. So that equation, if I, what's the rate in Massachusetts, for example, Brian, for a muni bond fund that one might typically get or a municipal bond example? Am I in the ballpark saying 3%? Three and a quarter, something like that? I think three would be generous. I don't have it in front of me right now. So let's just use that as an example. Let's say 3% at a 23% tax rate.
Is that what you said? I said, you're 22 in the federal five on the state, you know, so that's 27, right? 22 and 27. So that gives us 73% we're gonna divide. You would get 4.1% under that scenario, which still doesn't, you know, make the treasury less appealing. You're still better served. Here's the added caveat to this, right?
Even in a state like California or state like Massachusetts, where the credit, the credits are usually pretty good, you know, but they're not, they're not guaranteed by any stretch of the imagination, especially when it comes to, you know, like specifics. Sometimes you can buy a hospital, which is considered a municipal bond. And, you know, we've seen here in Massachusetts, some hospitals go belly up, right? So these are not riskless like a treasury.
So you would have- Would you elaborate on the idea so that just what you're talking about is the difference between a general obligation, right? Something that's tied to a particular entity versus something that's tied to the taxing authority. Talk about these distinctions. Sure. So a general obligation bond is tied to the taxing authority.
So that means if you were to buy a bond in the state of California, the revenues from the state of California, the taxing authority from the state of California is on the hook for paying the bond. There's also something called a revenue bond. Now a revenue bond is tied to a specific project. So let's say, you know, you're building- Talking about the hospital example, or they're going to- Yeah, you're building a hospital or toll booth or something like that.
The revenues of those projects need to support the interest payments and- It's specifically tied to that limited revenue capacity. Yeah. So there is credit risk in some of these bonds. So comparing it to a treasury, even though the math did not work against the treasury, is not an appropriate comparison. You have to compare it to, let's say, an A-rated bond, right? Which will get a spread over treasury.
So you're really looking at something, you're comparing it to maybe five and a quarter, five and a half percent, which- It's maybe even a harder equation to overcome and say, oh, there's value and benefit in getting that tax-free rate. Because for a credit equivalent, you really should be looking at something that pays even more in the corporate or in the taxable setting than what that tax-free bond will yield you in comparison, in an after-tax equivalent comparison.
So let's say that hypothetically that the math works out, which for very few people it does, for very few occasions it does. But let's say you live in New York or California, you make a ton of money. Good for you. Congratulations. I'm happy for you. And this equation works out for you. What do you do? Well, or what are the problems? Well, if you're in California, you really only want to own California municipal bonds. If you're in New York, you really only want to use New York municipal bonds.
So what does- Because of what I mentioned earlier, just because you own a municipal bond, if it's not your state that you're taxed in, it still could be taxed. Right. So you don't necessarily just want to buy an ETF of diversified bonds. So diversification becomes a real problem. It becomes a real challenge. And why do I say California and New York? Those are typically the highest taxed states. They're typically the states where this math might make sense.
Yeah. Remember in New York, you can be taxed not only on state, but municipality level as well. There could be income tax implications. So yeah, it works more effectively. Yeah. And the more money you make, the more that marginal tax rate makes sense and the less the effective tax rate makes sense. So there's more opportunity for this to make sense for you individually. But going back to my point, it's really hard to get diversified. Now, here's some other things that people should know.
Only the interest is tax deductible. So what does that mean? You have to buy bonds at a premium. So most municipal bonds are priced at a premium. So what does that mean? If at the end of maturity, you get a hundred dollars, most of the bonds are priced over a hundred dollars.
Sorry, Brian. If I'm not buying the bond at inception, but I go out and buy it on the marketplace after it's already been issued from someone else who bought it previously, that's when I'm facing this issue of premium that you're talking about. Yeah. If you can buy a premium bond, that's actually a good thing because then all your interest expense will be shielded from tax.
But if you have to buy a bond at a discount, so rates go up since it's been issued and you buy the bond at a discount, that amortization towards par is going to be taxable because it's going to be considered a realized gain when it matures. So you might not get the stated yield to maturity all tax-free in that circumstance. So that math that I mentioned, that tax equivalent yield does not work if there are bonds that are trading at a discount in the portfolio. So you got to buy premium bonds.
You got to buy bonds in the state. It helps if you buy new issued bonds, you're going to have some credit risks, specifically from those revenue-oriented type bonds rather than the general obligation bonds. Finally, the duration of these bonds, the maturities are typically longer. When you buy a fund for sure, you tend to buy a longer duration within a fund than you might choose to otherwise. So what does that mean?
There's some inherent interest rate risks, more inherent interest rate risks than there would otherwise be. So you put all this together and are municipal bonds for you? The answer is probably not. I know that people like them and I always say that they're great for the issuer. They're great for the state. They're great for the municipality. They may not necessarily be great for you as an investor. So a lot of complexities to consider. There's a lot of variations.
It's not purely the interest rate consideration, but who's the title we gave this episode is when to buy municipal bonds. Let's kind of sum that up. It's when you're in a very high tax bracket, when you're in a very high tax state, these might be the circumstances where the math can work, but you have to be very selective. And it's often the case that you're still better off to buy taxable bonds because you can net more even after paying taxes. And you might have less duration risk.
You might have less capital gain consideration in this, or it might give some of these things that you're not anticipating can muddy the waters. Yeah. Going back to the effective tax rate versus marginal tax rate. If your effective tax rate is approaching your marginal tax rate, you might want to look into it. I mean, you make enough money where the math will more often make sense. And that's why I say that we ignore the effective tax rate and the marginal tax rates, the textbook reason.
But I think it's fair to consider the effective tax rate, given that it's so common for people to inappropriately get into these types of instruments. So yeah, sometimes it sounds better than it actually is when it comes to municipal bonds. Who doesn't like the idea of avoiding tax? But I think most people would say, all right, I can save you taxes, but you'll make less money net even after tax. Is that what you want to do? Most people would say no. So anything else to add?
What do you think, Jeff, Brian? I think we hit it. That's less frequently desirable for people. What were you going to say, Jeff? I was just going to say the analysis that we're doing today is based upon the current treasury rates, right? So if you saw significant changes in treasuries, that would change the analysis, but have to be quite a change to make it meaningful for most people. If there's a change in treasuries, it's probably a change in the municipal bond yield curve too.
I mean, there are opportunities. I'm not saying it never happens. I'm just saying it's rare. Um, Chris, if you have a second, I mean, I'd love to revisit that. Yeah, the 2020 or whatever. Yeah, that was a great experience. Uh, so that was kind of, as we all know, it was a wild time though. Yeah. Right. And what I called that was an occluded event, right? Like people were just running the doors. I need cash. I need cash now. I don't care what price.
And when people do that, the markets get really distorted and there's oftentimes really good opportunities in really strange places. This was a time when we actually put municipal bonds across all accounts, regardless of its tax status, because we weren't in it for the tax equivalent yield. We were in it for the likely capital gains that was going to come from a wild mispricing.
So, um, at that time you bought treasuries and sometimes we were using high yield in place of equities as a place, as a way to take less risk to get, uh, tax equity, you know, to get essentially a risk equivalent of stock returns without having to take as much risk in the process. Yeah. I mean, that's how it ended up. Right. So, um, if you guys remember back then the federal reserve, Jerome Powell, uh, came out and said, the federal reserve will basically backstop on municipal bonds at 5%.
We'll refinance any municipal bond at 5%. So that essentially put a 4 on all bonds at a 5% yield and the bonds were trading well above 5%. Um, it was an incredible opportunity. So there was an arbitrage there that closed within two months, um, where, you know, we could take that excess duration, um, put it in people's portfolios and know that it would make a ton of sense for these bonds to fall, you know, at least 1%, but likely more than that, um, as they came into equilibrium with treasuries.
And I think we ended up making like a 19% return on it within a few months. Um, so anomalies happen. Um, I'm happy to take advantage of them when they do, uh, but they're few and far between and usually in some kind of a unique situation in this case, the pandemic. Yeah. So, um, but your point, Jeff was, um, I think, uh, one that's worth mentioning that notion that things change, right. And it's, uh, worth, uh, you know, revisiting when there are different circumstances.
As it stands today, by and large, we would encourage people to think more in terms of taxable bonds because of the net math. Um, but like you said, you know, it's not static. You got to check it out from time to time. Hey, this was a good conversation guys. Thanks so much. And for our listeners, um, you know, listen, if you're thinking about your portfolio and maybe you have municipal bonds in the mix and wondering, is it the right thing?
Maybe it's something you've wanted to think about and you want to get a little bit more into the weeds. We can look at things in the particulars of your financial plan and your portfolio and see if we can help you navigate what's best for your circumstances. If you need a little hand with that, don't hesitate to reach out to us. In the meantime, thanks for being with us until next time, everybody keeps driving for something more.
Thank you for listening to something more with Chris Boyd, call us for help, whether it's for financial planning or portfolio management, insurance concerns, or those quality of life issues that make the money matters matter. Whatever's on your mind, visit us at something more with chrisboyd.com or call us at 866-771-8901, or send us your questions to amr-info at wealthenhancement.com.
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