A properly diversified portfolio should contain a healthy array of different types of investments. One of these investments may be tax-exempt bonds.
What are tax-exempt bonds?
Tax-exempt bonds are municipal bonds. In finance slang, they are commonly referred to as “munis” or “muni bonds”. Municipal bonds are issued by states, counties, municipalities, hospitals, schools, airports, and so on. When you buy these bonds, you are effectively lending money to these government or nonprofit entities. Typical uses for these funds includes construction and maintenance of infrastructure like buildings, bridges, roads, water, sewer, power, etc.
Why do you want to own them?
Simply put, taxes. Unlike most stocks, many bonds are taxed at ordinary income tax rates. Here is a quick illustration of that point. Assume you are taxed at a rate of 25%. You can go out and purchase a corporate bond with a 4% coupon (a coupon is an income you receive from a bond) or a tax-exempt municipal bond with a 3.25% coupon. Now, go ahead and knock 25% of the return off that corporate bond. Your 4% coupon just turned into a 3% coupon. So, assuming all else is equal between those bonds, you should purchase the tax-exempt bond because 3.25% is greater than 3.00%.
What’s their role in a portfolio?
Municipal bonds generally have high credit ratings and can provide a strong ballast for your taxable portfolio. That isn’t to say they’re riskless investments. All investing involves some degree of risk, but municipal defaults are few and far between. That does not mean there shouldn’t be a fair amount of research done before purchase. In the USA, there are more than 85,000 entities that can issue munis, with over 3 million options currently available. If you already have a taxable portfolio with us, it’s likely we’ve already invested a substantial portion of it in tax-exempt bonds.
As always, we’re happy to visit with you about investments or your account. Give us a call at 701.235.2002 or drop us a line at [email protected]