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Municipal Bond Yields and the Return of Tax-Exempt Income

The municipal bond yield revival is not simply an issue of time. As state and local income tax revenues have increased at a rate not seen in over two decades, investors are reducing their near-term worries over the creditworthiness of municipal bonds. In addition, issuers are utilizing the influx of new cash to develop emergency reserves, allowing them to achieve their budgets even during difficult economic times. While this influx of capital has led to higher yields, it also protects municipal bond prices.

Historically, municipal bonds were considered tax-exempt investments, but the Tax Cuts and Jobs Act has made this concept more challenging. The new rule restricts the refinancing of municipal bonds, reducing the appeal of tax-exempt bonds to overseas investors seeking tax-advantaged investments.

Municipal bonds allow investors to engage in tax-exempt income while maintaining capital. The government issues these bonds to raise funds for various reasons, including infrastructure projects. Municipal bonds pay interest on a predetermined schedule for a predetermined duration. At maturity, investors get the initial investment amount in full. This form of investment may be advantageous for retirement savings but may not be suitable for all individuals.

The interest income generated by municipal bonds is normally free from state taxation in the issuing state. However, investors may be required to pay taxes on their capital gains. Additionally, certain investors may be liable to the Alternative Minimum Tax (AMT). However, as long as municipal bond yields are held to maturity, they remain tax-exempt.

Inflation and insolvency are two of the risks connected with municipal bonds. However, the greatest possibility is that huge bond issuer may have financial difficulties. Puerto Rico, for instance, filed for bankruptcy in 2017 with over $70 billion in bond debt and $50 billion in unfulfilled pension commitments. Nevertheless, it emerged from a financial restructuring process with a plan to repay its creditors.

Despite the inherent risk of municipal bonds, investors should consider diversifying their portfolios across several sectors to improve their sector exposure. Municipal bond benchmarks are diverse, and diversification should be based on risk characteristics. A diversified, multi-sector strategy should balance credit and interest rate risk while catching risk-adjusted opportunities.

Municipal debts can be categorized as either general obligations or revenue bonds. General obligation bonds are municipal bonds with the lowest risk and yield. On the other hand, a revenue bond is supported by the facility’s income. Special tax and industrial revenue bonds are examples of other municipal bond kinds.

Changes in interest rates, market circumstances, and the issuer’s credit rating can contribute to the market discount on municipal bonds. A municipal bond is classified as a market discount bond when the discount surpasses a particular threshold. This form of bond is considered a market discount bond by the IRS.


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