Unlocking the Power of Tax-Free Investments Why Municipal Bonds Deserve a Place in Your Portfolio

Introduction

• "In today's video, I'm going to explain why municipal bonds are worth having in your portfolio, which happen to be tax-free investments federally and potentially tax-free at the state level if you buy them local to your area."

What Are Municipal Bonds?

• "For those of you that aren't familiar, municipal bonds, or munis, are just like any other bond where you, the investor, are loaning out your hard-earned money to a city or state government agency. They'll pay you back interest on a regular interval, roughly every six months, and when it reaches maturity, you will be paid back your original investment, also referred to as the principal."

Tax Advantages of Municipal Bonds

• "What makes munis so appealing is that they are not taxed at the federal level, and if you purchase them specific to your community, they are probably free of taxes at the state level as well. However, you'll need to research the bond on your own to verify those details."

Why Isn't Everyone Investing in Municipal Bonds?

• "You may be asking yourself, 'If munis are tax-free investments, why isn't everyone investing in them?' The reason is simple: the rates tend to be quite a bit lower on munis than the rates on most other bonds. However, if you're in a higher tax bracket and live in a state with high taxes, municipal bonds could offer you a much better yield."

Comparing Municipal Bonds to Other Investments

• "Let's illustrate this by comparing a municipal bond at 4% to a CD (Certificate of Deposit) at 5%. For this example, let's say that you live in New York, where your gross income is $150,000, and your effective state tax rate is 4.94%. Entering that into a tax-equivalent yield calculator like this one from Bankrate shows that your 4% municipal bond has a tax-equivalent yield of 5.33% from saving on federal taxes, and it is up to 5.61% if you combine federal and state tax savings."

Key Risks Associated with Municipal Bonds

• "Now, there happen to be two key risks associated with municipal bonds: interest rate risk and credit risk."

Interest Rate Risk

• "The first is interest rate risk. Let's say you buy a municipal bond today at 4%, and in one year, that rate goes up to 5%. Since your bond is locked in for potentially years on end at 4%, you're going to miss out on that higher 5% rate. If you wanted to sell yours early on the secondary market, you would lose money because you'd need to offer a discount to compete with the new bonds at 5%."

Credit Risk

• "The second major risk is credit risk. Whoever owes you money may default on the loan or bond. Government bonds are seen as zero or no risk because the U.S. can essentially print more money, but overall, they simply pay their debt. Local government bonds like munis are seen as very low risk, but not as low as government bonds. Corporate high-yield bonds offer a much higher yield but come with a higher risk of default."

Understanding Credit Ratings for Municipal Bonds

• "One thing I really like about municipal bonds is that they're given a credit rating to assess the creditworthiness of the state or local government issuing the bond. The ratings are based on factors like the issuer's financial condition, the strength of its economy, and the security of its revenue stream."

Where to Purchase Municipal Bonds

• "Where can you even purchase them? This is a question I often get, and the most common place to buy them is from your brokerage site or an exchange like Fidelity, Vanguard, or Schwab. They have a dedicated section that lists municipal bonds offering either new or previously owned ones sold on the secondary market."

Resources for Researching Municipal Bonds

• "Another question I often get is, 'What resources do I use when I'm researching for my stocks and investments?' I often use brokerage sites for performance information, but I also like to get as close to the source as possible with sites like NASDAQ."

Understanding Bond Basics

• "I think it's important to start off by describing the process of buying a bond in very general terms. When you buy a bond from an exchange, the price that you buy it for, let's say it's $1,000, is called the par value. It's the value it is originally sold for, and it's the amount that you'll be given back at maturity."

Buying Municipal Bonds in Taxable Accounts

• "Another basic item to consider with municipal bonds is that they are meant to be purchased in your taxable account due to the tax savings with these bonds. So for this reason, you would not want to buy them in your 401(k) or IRA because the tax savings you get from munis are completely lost in these types of tax-advantaged accounts."

Purchasing Municipal Bonds on Fidelity

• "Now, when looking to buy a municipal bond, I'm going to use the website Fidelity simply because they have a bit of a cleaner view, and that happens to be my preference."

Conclusion

• "Reducing risk and finding gains is a tricky balance, but we can raise our portfolio's floor and ceiling by diversifying across assets. If you're interested in learning more about how to manage risks with municipal bonds, let me know in the comments. Thanks for watching, and don't forget to like and subscribe for more investment tips."