At the core of munis’ appeal is their primary tax advantage: federal tax exemption on interest income. Unlike traditional taxable bonds, munis generate interest typically exempt from federal income tax. This feature becomes especially powerful for investors in higher marginal tax brackets, where the after-tax returns can substantially outperform comparable taxable investments.
A potential double-layer tax protector?
The tax benefits extend even further for investors residing in the state or municipality that issues the bond. Many states provide additional tax exemptions for munis issued within their jurisdiction, creating a potential double layer of tax protection. This can translate to meaningful tax savings for high-income earners in states with significant state income taxes, such as California or New York.
Example
An investor in the 37% federal tax bracket receiving $10,000 in muni interest would effectively keep the entire $10,000. In contrast, the same interest from a corporate bond might result in a significantly reduced after-tax return. This tax-equivalent yield can make munis particularly attractive for those seeking to maximize their investment income.
Tax-loss harvesting opportunities
Tax-loss harvesting represents another sophisticated strategy where munis shine. Investors who have experienced losses in other parts of their portfolio can strategically use munis to offset capital gains while maintaining investment exposure. The relatively stable nature of municipal credits, particularly those with shorter durations, allows investors to manage tax liabilities without sacrificing portfolio stability.
Yield curve volatility
The slope of the yield curve has remained volatile this year as investors navigate the path between a soft landing and a higher for longer stance from the Fed. We believe this volatility will continue as re-inflationary risks as well as fiscal budgeting put pressure on long-term rates
Managing duration risk with shorter-duration muni bonds
Right now, investors face greater interest-rate risk than they have in recent history.
Short- and ultra-short duration muni bonds offer additional strategic advantages, especially during periods of market volatility. These instruments provide investors a low-volatility option within the fixed-income market, allowing for more predictable returns and enhanced tax-loss harvesting opportunities. We believe the current market environment, characterized by economic uncertainty, makes these characteristics particularly valuable.
A broader economic role
These investments directly support critical local infrastructure projects, from school construction to transportation improvements. By investing in municipal bonds, individuals benefit financially and contribute to community development.
Risk management
Munis historically demonstrate lower default rates than corporate bonds, providing an additional layer of security. Credit ratings from agencies like Moody's and Standard & Poor's offer transparent insights into the financial health of bond issuers, enabling informed investment decisions.
Furthermore, diversification across different municipalities, sectors, and bond types can help mitigate potential risks.
Final thoughts
Munis represent more than just a financial instrument; they are a sophisticated tool for tax-efficient investing. We believe the tax advantages of munis are not merely theoretical but can represent substantial real-world savings. An investor in the highest federal tax bracket could potentially save thousands of dollars annually through strategic muni investments. At these elevated absolute rates, the value of the tax exemption itself becomes more valuable to the investor; this is why we believe now is a good time for investors to build or add to their tax-exempt exposure. Moreover, these savings compound over time, creating a powerful long-term wealth-building mechanism.
1 Diversification does not ensure a profit or protect against a loss in a declining market.
Important information
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
Indexes are unmanaged and have been provided for illustrative purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
High yield securities may face additional risks, including economic growth; inflation; liquidity; supply; and externally generated shocks.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Moody's is an independent, unaffiliated research company that rates fixed income securities. Moody’s assigns ratings on the basis of risk and the borrower’s ability to make interest payments. Typically securities are assigned a rating from ‘Aaa’ to ‘C’, with ‘Aaa’ being the highest quality and ‘C’ the lowest quality.
Standard & Poor’s credit ratings are expressed as letter grades that range from “AAA” to “D” to communicate the agency’s opinion of relative level of credit risk. Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. The investment grade category is a rating from AAA to BBB-.
The tax implications of tax management techniques, including those aimed at harvesting tax losses, are complex and uncertain, and they may be subject to challenge by the IRS. Please note the following: (i) any discussion of U.S. tax matters contained in this communication cannot be used to avoid tax, penalties, or interest imposed by the IRS or any other taxing authority; (ii) this communication has been written to support the promotion or marketing of the subjects discussed herein; and (iii) you should seek advice tailored to your specific circumstances from an independent tax advisor. Neither Aberdeen nor its affiliates provide tax advice.
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