Municipal Bonds

Municipal bonds, munis, are debt issued by states, cities, counties, and public agencies to fund roads, schools, water systems, and general budgets. They come in two flavors. General obligation bonds are backed by the issuer's taxing power; revenue bonds are backed by the income of a specific project, a toll road or a water utility. Interest is exempt from federal income tax, and usually from state tax for in-state residents, which the IRS details in Publication 550.

The exemption is the entire pitch, and it has boundaries. Capital gains on munis are taxed like any security's, private activity bonds can fall under the alternative minimum tax, and out-of-state interest is usually taxable at home. The credit spectrum runs from AAA general obligations to junk-rated issuers. Defaults are rare but not zero: Detroit in 2013 and Puerto Rico in 2017 are the modern reference cases. The MSRB's EMMA database publishes every muni's official disclosures for free.

The pricing: munis yield less than Treasuries of the same maturity because of the tax exemption, and the gap is quoted as a muni-to-Treasury ratio. The decision arithmetic is the tax-equivalent yield: muni yield divided by one minus the marginal bracket. A 3.4% muni at the 32% bracket is 3.4 divided by 0.68, or 5.0% taxable-equivalent: a taxable bond would need to yield 5.0% to match it after tax.

The bracket does the deciding. At the 12% bracket, the same 3.4% muni is 3.86% taxable-equivalent, which most corporate and Treasury yields beat, so the muni is a poor trade. At the 37% bracket it is 5.4% taxable-equivalent, which beats most like-rated taxable bonds. The crossover lives in the low-to-mid brackets, which is why the first question is always the marginal rate, not the yield.

The state stack refines it: an in-state muni at 3.4% escapes federal and state tax, and at a combined 38% marginal rate is roughly 5.5% taxable-equivalent. The exceptions: private activity bonds are subject to the 28% AMT rate for affected taxpayers, and capital gains from selling a muni at a profit are taxed at normal capital gains rates, because only the interest carries the exemption.

Municipal bonds are the high-bracket investor's core holding and the wrong holding for everyone else, and the bracket arithmetic decides it in one division. A 5.0% taxable-equivalent yield at the 32% bracket beats most like-rated corporates; the same muni at the 12% bracket is beaten by nearly everything, and the exemption went to waste.

I watched a colleague named Brent (yes, that Brent) buy a national muni fund inside his Roth IRA, where every dollar of growth is already tax-free. He traded a 5% taxable-equivalent advantage for nothing: the exemption has no value in an account that pays no tax, and the taxable space would have paid him for holding it. The Roth held the muni; the muni held nothing.

The highest-leverage thing most Americans can do is put munis in taxable accounts at high brackets and tax-advantaged accounts everywhere else, and check a fund's AMT exposure before buying. Check the bracket with the marginal tax rate calculator and the after-tax comparison with the bond equivalent yield calculator.