For investors with significant taxable assets—typically those with investable assets exceeding $5 million—just generating returns isn’t the only challenge; there’s also the significant challenge of defending those returns against tax impact. Based on current prevailing interest rates, municipal bonds (collectively, "Munis" and each, a “Muni”) appear to have generated a renewed interest for wealth managers, based on perceived stability and tax efficiency.
What are Municipal Bonds?
Munis are debt securities issued by states, cities, counties, and other governmental entities to fund public projects, such as building schools, highways, or water systems. When you purchase Munis, you are essentially lending money to a public issuer in exchange for a series of interest payments and the return of your principal at maturity.
In most cases, the interest earned on Munis is not subject to federal income tax. Furthermore, if you purchase bonds issued within your home state, the interest is often exempt from state and local taxes as well—offering a "triple-tax-free" benefit.
The Florida Advantage: While the State of Florida has no state income tax, Florida Munis can be a staple for local investors who believe that the state has experienced historically sound fiscal management and that local issuers represent high credit quality.
The Tax-Equivalent Yield (TEY) Advantage
To appreciate the value of a municipal bond, it helps to look past the "nominal" yield and calculate the “Tax-Equivalent Yield.” This determines what a taxable bond (like a corporate bond) would need to yield to equal the after-tax return of a Muni.
Hypothetical Example: For an investor in the top federal tax bracket (37% plus the 3.8% Net Investment Income Tax), a municipal bond yielding 4.00% is equivalent in after-tax yield to a taxable bond yielding approximately 6.76%. [Note: This example is for illustrative purposes only. Actual TEY depends on your specific tax situation and investment options.]
Implementation & Risk Management
While many municipal bonds are commonly considered high-quality investments, like all securities, those investments are subject to risk. Therefore, when we allocate to Munis, we commonly consider the following risk factors and address them accordingly:
- Bond Laddering: By purchasing bonds that mature at different intervals, we can help manage interest rate risk (the risk that bond prices fall when rates rise). As shorter-term bonds mature, proceeds can be reinvested at then-current market rates.
- Credit & Inflation Risk: Not all Munis are created equal. We therefore distinguish between general obligation bonds and revenue bonds. General Obligation bonds are backed by the ‘full faith and credit’ of the issuing municipality whereas revenue bonds are backed by a specific revenue source, such as paid water utility bills. Professional oversight is helpful to ensure that the issuer's ability to pay remains strong and that yields keep pace with inflation.
- The AMT Factor: In some cases, interest from certain municipal bonds can be subject to the Alternative Minimum Tax, and it depends on the issuer of the bond. These bonds, called Private Activity Bonds, are typically projects that are for the public good but are being developed by a private entity.
Summary: A Tool for After-Tax Growth
For investors with $5 million or more in assets, the goal is often to sustain a lifestyle while growing a legacy. By integrating municipal bonds, investors can seek to keep more of what they earn, potentially reduce risk, and support the infrastructure of their communities.
Aviance Capital Partners, a wealth management firm in Naples, Florida, provides municipal bond portfolio management to clients.
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Aviance Capital Partners, LLC (“ACP”) is an SEC registered investment adviser located in Naples, Florida. Registration as an investment adviser is not an endorsement by securities regulators and does not imply that ACP has attained a certain level of skill, training, or ability. While information presented is believed to be factual and up-to-date, ACP does not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Not all services will be appropriate or necessary for all clients, and the potential value and benefit of the ACP’s services will vary based upon the client’s individual investment, financial, and tax circumstances. The effectiveness and potential success of a tax strategy, investment strategy, and financial plan depends on a variety of factors, including but not limited to the manner and timing of implementation, coordination with the client and the client’s other engaged professionals, and market conditions. This should not be construed as specific investment, financial planning or tax advice tailored to an individual reader. ACP suggests that readers consult a financial professional, attorney or tax advisory professional about their specific financial, legal or tax situation. Past performance does not guarantee future results. All investment strategies have the potential for profit or loss, and different investments and types of investments involve varying degrees of risk. There can be no assurance that the future performance of any specific investment or investment strategy, including those undertaken or recommended by ACP, will be profitable or equal any historical performance level. The index and sector performance data appearing or referenced above has been compiled by the respective copyright holders, trademark holders, or publication/distribution right owners.
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