Muni Bonds Explained: How To Incorporate Tax-Free Income With Investing For Retirement (EP.221)

0:28We all need to make smart decisions with our money. who have signed up to get email updates about my new book, The Perfect Portfolio. And when you sign up for these updates, you get a sneak peek of the book's outline as well as some early excerpts. And then I send updates every other Saturday. What's been really fun so far is that the feedback and engagement with subscribers has been off the charts. But the most surprising thing to me has been the interest in my chapter on bonds, as well as questions subscribers have about bonds in general. So today, we're going to talk about municipal bonds, what they are, when they make sense, and how to use them in a retirement-focused portfolio.

1:07If you'd like early access to book excerpts and invites to subscriber-only webinars, you can join the list at theperfectportfoliobook.com. Now, let's get into it. When clients ask me, do muni bonds make sense? I always remind them that every investment should serve a clear purpose. For individual investors, the primary role for both taxable or municipal bonds is reducing the overall volatility of your portfolio. But unlike most bonds, municipal bonds typically pay interest that is exempt from federal income taxes and, in some cases, exempt from state income taxes if you live in the issuing state.

1:47So comparing munis to corporate bonds or treasuries requires that we calculate a tax equivalent yield. The formula is pretty simple, and you can see it in the show notes at thelongterminvestor.com. It is simply the muni yield divided by one minus your federal tax rate plus your state tax rate, plus the net investment income tax. So suppose you're looking at a muni bond yielding 4%. If you're in the top federal bracket, which is 37 % for married couples filing jointly in 2025, plus the 3.8 % net investment income tax, your total federal rate is 40.8%. So if we're looking at a 4 % muni bond, you are going to say 4 % divided by 1 minus 0.408.

2:37What you're going to get is 6.8 % as your tax equivalent yield. So that 4 % muni is just as attractive as a 6.8 % taxable bond for someone in the top federal bracket. Now, if we keep with that 4 % example, the benefit grows once you account for state income taxes. And it's pretty meaningful whether you're in the top or second highest bracket. So if I were to look in Florida, for example, where there's no state tax, then that tax equivalent yield on a 4 % bond is still going to be 6.8%. But when I adjust the formula for, say, somebody in California, where the state tax is 13.3%, suddenly the tax equivalent yield becomes 8.7%.

3:22New York is another notoriously high state tax location. And if you adjust that equivalent yield for New York, you're going to see that it is 8.3 % rather than the 6.8 % tax equivalent yield we saw when we just factored in the top federal bracket. So that's your tax equivalent yield, and it's not perfect down to the decimal, but it's a quick way to see whether or not munis give you an edge over taxable bonds. Beyond the tax benefit, another reason that investors find munis attractive is the credit quality. Roughly 70 % of the muni market is rated AA or AAA, and defaults are historically rare compared to corporate bonds.

4:02Moody's data shows that the 10-year cumulative default rate for investment-grade munis is about 0.1 % compared to 2.2 % for investment-grade corporates. So, while defaults aren't unheard of, the muni market overall is widely considered to be one of the lowest-risk areas of fixed income. High-yield and non-rated munis, however, carry notably higher default risk. This sector of the muni market includes bonds financing speculative or thinly traded projects like charter schools, senior living facilities, or a local entertainment venue, many of which lack institutional investor interest. And so where you see them is often in individual investor portfolios.

4:43In fact, whenever I review a new client's portfolio at PlanCorp that holds individual bonds, either that they bought on their own or they got through a previous manager, I I usually see an uncomfortably large number of these high-yield state or local-only issuances, and I suppose that's not a surprise because brokers earn more selling them, and investors agree to them because of the high yields and the familiar narrative of investing locally. Now, while this might be one of the bigger mistakes I see investors making with municipal bonds, I do think that a very close second is investors favoring state-specific muni bonds.

5:22I laid out the math of how high that tax equivalent yield can be if you were to buy from the issuing state. And so it's pretty natural to ask, why not just buy munis from my home state and get the extra tax break at the state level? And yes, it is a fair question. If you're a California resident buying California bonds, you may avoid paying federal and state taxes on your interest. Or same goes for New York or Illinois or any state with a state income tax. And the math looks attractive, but there are three reasons I typically advise against it. The first is simply reduced diversification because by only sticking to your state, you concentrate risk in one economy, one political system, one pension system, and even one climate profile.

6:10So a wildfire in California or a budget shortfall in Illinois or a hurricane in Florida can all impact local credits, whereas a national muni portfolio spreads risk across all states and sectors. The second reason I usually advise against it is that there are fewer opportunities to enhance returns. And this is true anytime we're talking about bonds. When you shrink your opportunity set, you give up the chance to find higher yielding or more attractively priced bonds elsewhere. And so that national portfolio opens the door to more issuers and structures, both of which can improve diversification and expected returns.

6:50The third and most important reason that I typically advise against just buying the state muni bonds for the state with which you live in is that the market already prices in much of the tax benefit. There's actually a decent amount of research that shows that strong in-state demand often pushes local muni yields lower. In other words, there really isn't much of a state tax advantage because it gets competed away by the residents who bid up the prices. Now, you may still get some of the benefit, but definitely not as much as that headline tax equivalent yield math that I just shared would suggest.

7:25The tradeoff is that you end up more concentrated and less diversified, really probably for not as much tax benefit as you think. And so the takeaway is clear to me. A national muni allocation may give up a sliver of the state tax savings, but you gain broader diversification and access to a larger opportunity set that can introduce higher expected returns. And so that really can be the difference between what I would consider to be a narrowly tax optimized portfolio and one that is truly resilient. A third thing that always comes to mind when we're talking muni bonds is the decision to buy individual bonds versus bond funds.

8:05And I go deep on this in episode 97, which I will also link to in the show notes. Episode 97 is called individual bonds versus bond funds. And with an individual bond, I get it. You know exactly what you own. You know the issuer, you know the coupon, the maturity date, and bearing a default, you know what you'll get back. I get why that certainty appeals to many investors and help some people look past the price swings, but the trade-offs are real. For starters, you do really need a large amount of capital to build a diversified mini portfolio. And I tend to think that I don't really want to own individual bonds in my fixed income unless I can buy maybe$10 million worth of them because you really take severe haircuts in your yield when you buy them.

8:50That's really where the cost comes from. You don't get the bonds for free. They are basically taking haircuts off your yield and these odd lot transactions, and you have to transact in hundreds of bonds to get that diversification. You need a large amount of capital. The transaction costs are higher and the prices are less transparent, which I already kind of referred to. But then most importantly, you're taking on more of that idiosyncratic issuer risk where one bad bond can do pretty meaningful damage. Whereas if you are in a bond fund, whether it's an ETF or a mutual fund, you get that instant diversification across states, sectors, and maturities.

9:27You get professional credit monitoring where the data shows actually that there is a pretty big benefit to being active in the muni space in particular. There's a pretty big benefit to being active in the bond space, period. In fact, episode 99 titled The Problem with Investing in Bond Indexes is another good one to check out if you want to understand more about the bond space. But basically, there are a lot of inefficiencies that come from the fact that not everybody who owns bonds are doing it to maximize returns, which is not true with stocks at all. So yes, a fund's daily price will fluctuate, which investors will dislike for the, quote, safe part of their portfolio.

10:07But in practice, the benefits of diversification, the lower trading costs, the more transparency, and just the ability to have higher expected returns makes using a fund much more interesting. Now at PlanCorp, we typically only use muni bonds for investors in the top two federal tax brackets, which right now for married filing jointly is 32 % and 37%, because that's where we feel like the tax-exempt income truly changes the math. But even then, we don't build portfolios that are 100 % munis. And the reason is the same logic that we would apply when avoiding state-specific funds. Because if we only do munis, we are really shrinking the opportunity set, and you give up chances to enhance after-tax returns and improve diversification.

10:52So we like to combine munis with other fixed income types, regardless of your tax bracket. We will own treasuries, corporates, securitized bonds, preserving this larger opportunity set and making the portfolio more resilient. Now, the other thing that I did mention briefly, and I'm now seeing here in my notes, so I guess I front ran the point a little bit here is that, yes, we do prefer actively managed muni funds. Bond indexes are not like stock indexes. So in stocks, the index weights companies by market cap, which tells you something meaningful about investor consensus. But in bonds, the index weights are based on amount of debt outstanding.

11:32And so that means that the most indebted issuers end up being the largest positions in the index. Not necessarily the safest or most attractive bonds, just the people with the most debt get the biggest weight. It's a little backwards for bonds relative to stocks. The other thing is that liquidity is so important in the muni market. Many individual muni issues trade pretty infrequently. You can go 12, 18, 24 months between trades. And so skilled active managers have these opportunities to navigate liquidity gaps while index funds are forced to buy and sell bonds at pretty inopportune times. I think in general, and I mentioned the episode earlier, episode 99 titled The Problem with Investing in Bond Indexes, really can help you educate yourself on what I think is a pretty misunderstood part of bond investing.

12:23Whether you're implementing through mutual funds or ETFs, the principles with implementation in the muni space are pretty much the same. You want to focus on investment-grade credit quality. You want to diversify across a broad national pool of issuers. You want to avoid concentrating 100 % of your bond allocation in munis. And you want to favor actively managed strategies that can sidestep the pitfalls of bond indexing. Now, one last set of ideas before I close out. and I went back and forth on whether or not I should give a quick muni market outlook. Part of the reason I chose munis as the first place to focus on bonds is that they haven't done so well in 2025.

13:03They've really lagged most other parts of the bond market, primarily because there's heavy issuance from cities and states. They've been flooding the market with new bonds. There are higher construction project costs that have pushed municipalities to raise more money. but there were also many people rushing to the market ahead of potential federal tax law changes in the One Big Beautiful Bill Act that could have affected muni exemptions. Now, those didn't come to pass, but as with any market, when supply rises faster than demand, prices weaken. I don't think I'm oversimplifying it by saying that's why the broad muni benchmarks are roughly flat on the year, whereas the broader bond market has posted pretty strong returns.

13:43The good news is that yields are now at some of their most attractive levels in the past decade. For a 20-year AAA muni yielding 4.3 % today, using that tax equivalent yield calculation I gave you, that means for the top federal bracket, that's translating into a 7.2 % yield, which is pretty compelling. But another lens that you can use is the muni to treasury ratio, sometimes called the MOB or the mob spread. and the ratio compares the yield of a muni bond to a U.S. Treasury of the same maturity before adjusting for taxes. And right now, especially on the long end of the curve, you can see that 30-year munis yield about 94 % of treasuries.

14:25So after factoring in the tax exemption, that tilts strongly in the favor of munis. And this kind of relative value analysis helps us judge when munis will be fairly priced, expensive, or attractive compared to other fixed income options. This is actually probably the biggest reason I wanted to talk about the outlook is it's just hard to sometimes look at a part of your portfolio that isn't doing as well and wonder why am I in this and when is it going to get better? You're trying to make municipal bonds like anything else, a tool for planning for retirement. And I think they can be a really high powered tool for high income investors, but only if you use them thoughtfully.

15:04So I think you have to look at the tax equivalent yield, stick with investment grade credit and favor broad national exposure rather than trying to concentrate in a single state or chasing some of the eye catching yields in these non-rated issues. Now, remember, bonds aren't a placeholder for cash. They will help lock in income. They will add potential for price appreciation if interest rates were to fall. And number one reason that you own bonds is that they provide diversification that smooths out the ride of an equity-heavy portfolio. As a reminder, if you want more on this topic and an early look at my new book, The Perfect Portfolio, you can join the email list at theperfectportfoliobook.com.

15:46You'll get excerpts, behind-the-scenes updates, and invitations to subscriber-only webinars. As always, thanks for listening, and until next time, to long-term investing. Thanks for listening to the Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

16:29Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.