Benjamin Franklin said that nothing in this world is certain except death and taxes. However, investors have proved him wrong because there are ways to ensure that you do not pay taxes and still be on the right side of the law. Municipal bonds allow investors to generate tax-free income through interest payments received from state and local governments. Besides, municipal bonds pay interest twice a year, making them a great investment option for retirees who can be guaranteed income. Despite such advantages luring many hopeful investors into sinking their money in municipal bonds, there are reasons not to like them, and here we shall discuss five of them.
1. Cashing-In Losses
GoBankingRates cites that one disadvantage of investing in municipal bonds is the difficulty you might encounter when trying to cash it in, especially if you live in a remote area. Trading municipal bonds usually occurs in a market similar to the stock market, and you can choose to sell yours at the price a buyer is willing to pay or set a certain price and wait for someone willing and ready to buy it to approach you. The municipal bond trading market is not as liquid as that of the stock market, meaning the chances of finding a buyer are low. Even if you are lucky to find one, you will not like that once the buyer pays you the interest due to the bond up until the date of sale, you will not receive any more future interest due to the bond. As a result, if you had bought the municipal bond for predictable income twice a year as you await the return of the principal amount, you will have to look for alternative sources of income once you cash in your investment.
2. Not Tax-Free
According to the CPA Practice Advisor, municipal bonds are not entirely tax-free. Although the federal tax income tax has exempted interest payments obtained from municipal bonds from taxable income, the US Supreme Court upholds a state’s ability to tax interest on bonds issued in other jurisdictions. Simply stated, interest income received from municipal bonds issued by an entity from another state is subject to income tax. Also, having basic investment knowledge is important because investors will know that buying municipal bonds at a discount exposes them to capital gains tax. Municipal bonds bought in the secondary market at less than par value are obtained at a discount. An investor might pay more for a bond less valuable, going by the net present value, because the gain is subject to capital gains tax. It is, therefore, advisable to consider the price of the bond and the yield to maturity to determine if investing in the municipal bond will have tax consequences.
3. Low Yields
The general rule of thumb in investing is that the lower the risk involved, the lower the returns. Municipal bonds fall in the low-risk category meaning that you should not expect high yields. The stability of municipal bonds hardly compares to that of stocks that keep fluctuating. Besides, you can calculate the value to expect by adding up the bond’s face value and the interest paid, making your interest payment predictable. Investopedia explains that municipal bonds have a lower yield rate compared to taxable equivalent bonds because of the tax benefits obtained. Additionally, municipal bonds have lower yields because they are issued by the government, which makes them a great investment tool for risk-averse investors. That is not to say that municipal bonds have lower yields. There are high-yield municipal bonds that offer around a 3% higher interest margin, but they also carry a lot of risks than their lower yield counterparts. For instance, high-yield municipal bonds are less liquid, have higher default risk, and are more affected by interest rate risk.
4. Default Risk
Bond View explains that default risk is the possibility that the debt will not be repaid when it falls due and that any security issued by the federal government is considered risk-free. As a result, municipal bonds rank second in the category of safest securities issued by the federal government. However. that is not to say that municipal bonds are 100% default risk-free. When the COVID-19 pandemic struck the financial market, investors were worried that federal and local governments would be unable to service their debts due to increased expenditure and reduced income. Besides, there is a history of municipal bonds being defaulted, with the largest incident being in the 1970s when $2.25 billion in bonds remained unpaid. The amount had been borrowed to build five nuclear power plants but only one was completed.
5. Interest Rate and Inflation Risks
While the risk of default is much lower in municipal bonds, interest rate risk is high. Interest rate risk refers to the potential that an adjustment in interest rates will cause the value of a bond to go down. Usually, the longer a bond’s maturity, the higher the risk. Therefore, MSRB warns that municipal bonds investors should understand how bond market prices are affected by economic cycles. The article adds that investors should familiarize themselves with the meaning of a term such as “duration” and factors affecting it to make informed decisions. Inflation affects all types of investments, and municipal bonds are not exempt. Since inflation refers to the decreased purchasing power per unit of currency, investors also worry about the reduced value of their fixed-income returns. Although some sources cite municipal bonds as being safe from the effects of deflation and inflation, there is still that 1% or less risk associated with such investments. If you buy a bond with 9% coupon payments and the inflation is 2%, the returns will have to be adjusted for inflation, meaning that you should expect returns calculated at 7%. An increase in inflation reduces inflation-adjusted returns for fixed-income returns, and with time, you will feel the financial loss reflected in your portfolio.
Written by Allen Lee
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