Investors in municipal bonds took it on the chin last year after the Fed’s “tapering” policy sparked fears of rising interest rates, while Detroit’s bankruptcy filing redefined the term “default risk.” Still, a solid case remains for municipal bonds — especially if you’re a fixed-income investor who wants to protect your nest egg from the tax man.
Munibond investors typically pay no federal taxes on their interest income — and similar state and local tax breaks are often available if you buy bonds issued in the same state where you live. So municipal bonds’ tax-free status is a boon for higher-bracket taxpayers who will see an additional 3.8% Medicare tax on their investments this year — on top of a rate increase from 35% to 39.6% for the top tax bracket.
Municipal bonds come in two flavors — revenue bonds and general obligation (GO) bonds. Revenue bonds fund improvements in projects like airports or power plants that generate income. These bonds can repay investors only from that income. In a GO bond, municipalities can raise taxes to repay bondholders.
There’s more good news: Detroit and the California cities notwithstanding, bankruptcy filings or defaults are rare occurrences in the munibond sector. And while interest rates are a headwind, the Fed is likely to go slow in its efforts to scale back its own bond buying in the months to come — and that policy has largely been priced in.
That said, here are three plays on municipal bonds that can ease the tax headache for top-bracket investors: