09 Nov Are municipal bonds right for me?

Q. How can I decide if I should have municipal bonds? Is there a formula or something?
— Investor

A. There’s not usually a reliable formula to determine if you should invest in a certain kind of security, but when it comes to municipal bonds — commonly called munis — there is a formula that can help you make the decision.

Muni bonds are issued by local governments and states and provide income that is free of federal taxes, and may also be free of state and local taxes, said Altair Gobo, a certified financial planner with U.S. Financial Services in Fairfield.

Gobo said in order to decide if muni bonds are right for you, you need to know your federal tax rate. You simply subtract your tax bracket from 100 to get your “reciprocal rate,” and then divide the muni bond yield by the reciprocal rate.

The formula is:

           Muni Bond yield         
(100 – your federal tax rate)

Gobo offered this example: Let’s suppose you are in the 28 percent tax bracket (100 – 28 = 72). Your reciprocal rate is 72. Now let’s suppose you are buying a muni bond with a 3 percent yield. Divide the 3 percent yield by your reciprocal rate of 72 (3 divided by 72 = 4.16).

“The 4.16 percent is your tax-equivalent yield,” Gobo said. “In other words, if you can get more than 4.16 percent from a taxable investment, it makes more sense than a muni.”

Now that you’ve done the math, there’s more to consider.

Although munis may offer attractive tax-free income and a potential hedge against equity risk, you have to be aware of the risks, Gobo said.

“Even though our economic environment has not been vibrant for the last 10 years or so, default rates in munis have remained low. That scenario is not guaranteed,” Gobo said. “Municipal bonds carry risk — some states or municipalities carry more risk than others — and you need to do your homework.”

He said you should also look at whether you should buy individual bonds or bond funds.

The advantage of buying individual bonds is that they have a finite maturity date at which time you get your money back, assuming the issuer does not default. The disadvantage is you need to get adequate diversification, Gobo said.

“Mutual funds and exchange-traded funds (ETFs) could provide diversification, but the tradeoff is they do not have finite maturity dates and you may suffer unrecoverable losses,” Gobo said. “In any case, it pays to do your homework so that you can match your time horizon and risk tolerance with the proper muni choice.”

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This post was first published in November 2016.