“Once you reach a certain level of wealth, the conversation shifts. We aren’t talking about accumulating anymore; we’re talking about preserving.”
This is how Nick Goetze, managing director of Fixed Income Solutions at Raymond James, frames things when he talks about bonds. And when it comes to preserving your wealth, some bonds are built differently.
“The first priority with bonds is principal preservation,” says Nick. “In certain high-tax situations, individual investment-grade municipal bonds can be one of the better options to accomplish that goal.”
Tax appeal
Issued by city, local and state governments, municipal bonds are loans used to build infrastructure – road expansions, new hospitals, school improvements, water and sewer maintenance, etc. What makes them an attractive opportunity for high-net-worth investors is how they are – or aren’t – taxed.
These instruments are typically exempt from federal income taxes and often state and local taxes. For someone in a higher tax bracket, interest income from municipal bonds offers a way to generate a tax-free cash flow to fund their lifestyle or meet other objectives while seeking to preserve principal.
A highly tailored approach can be used to create custom portfolios for each client, but the ultimate goal for municipal bond investors is nearly always the same.
“It’s about maximizing net income to your pocket,” Nick says. “In many cases with investors in a higher tax-bracket, you would have to generate a significantly greater return to get to the same after-tax returns offered by muni bonds. Each investor’s situation determines what type of fixed income security generates the best net return.”
Thinking local
In a financial environment where operations are often centralized, municipal bonds represent a part of the market where location still matters. Working with local professionals can make all the difference when it comes to muni investing.
Unlike bond markets where things can be more universal – corporates, Treasuries, agencies, mortgage-backed securities, CDs – munis are very local. There can be value in having traders live in the states and communities they trade in and in working with professionals who have local experience. “There’s a lot of nuance, knowing that this county has a slightly better credit quality than the county next door, so that local knowledge can be powerful,” says Nick.
In- or out-of-state?
While thinking local can help ensure investors find the right bond to meet a need, those interested in municipal bonds don’t have to stay local. Buying out-of-state bonds can be a good strategic option, especially for investors living in places with no state income tax.
“States that don’t have an income tax don’t penalize you for buying out-of-state muni bonds,” says Nick. “So if you’re in Tennessee and buy a bond from North Carolina, there’s no state income tax on the income from that out-of-state bond. Same thing in Texas. Same thing in Florida. If you live in a low- or no-income-tax state, it’s often beneficial to look around the country for the best yields and credit quality.”
In some cases that math can even favor out-of-state bonds for those in states where they’re taxed.
“Sometimes getting all state-specific bonds is difficult so the question becomes, ‘How much more do I need to earn on an out-of-state bond to pay state income tax and net what an in-state bond could offer?’ That should always be part of the calculus to determine if leaving your state makes sense.”
Community building
Another element of munis is the potential financial benefit to investors is enhanced by the ability to generate benefits for their local communities.
“There’s often a piqued interest among investors when it’s a bond issued for a project in their backyard. It’s their water and sewer system. It’s their local hospital. It’s the college they attended. Those kinds of bonds tend to generate more excitement,” says Nick.
“I don’t know that people are investing purely based on the notion of supporting local infrastructure, but they’re often glad that’s part of it. However, sometimes you have to be mindful of certain loyalties. A University of Alabama bond may not be attractive to an Auburn alum.”
Not without risk
Like other high-quality fixed income securities, municipal bonds come with a lower degree of investment risk. However, “low” does not mean “no.”
According to Nick, defaults are extremely rare, but investors can’t ignore the possibility.
“I always stress the importance of safety. You buy bonds first and foremost to preserve wealth. What people need to watch out for is overconcentration. You shouldn’t own too large a percentage of any one issuer. As with equities, diversification is the key to mitigating risk.
“At the end of the day, no investment is perfect. But investment-grade munis offer high credit quality, known cash flow and the potential to generate an after-tax return that’s very attractive.”
Municipal bonds may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Investing involves risk and investors may incur a profit or a loss. Municipal bond investments involve credit risk, interest rate risk and market risk if sold prior to maturity. While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the federal alternative minimum tax, or state or local taxes. Diversification does not guarantee a profit nor protect against loss. A credit rating of a security is not a recommendation to buy, sell or hold securities and may be subject to review, revisions, suspension, reduction or withdrawal at any time by the assigning rating agency. Profits and losses on federally tax-exempt bonds may be subject to capital gains tax treatment. In addition, certain municipal bonds (such as Build America Bonds) are issued without a federal tax exemption, which subjects the related interest income to federal income tax.
Raymond James is not a tax advisor and does not give tax advice. Please consult a tax professional prior to making any investment decisions.
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