Avoid Municipal Bonds For Now

Those paying taxes this month in States like New York, New Jersey and California have been hit with quite a wake up call over the last few days.

Our tax bills, as a result of the 2018 Republican tax cuts, are much higher, especially since we have lost all sorts of deductions for our state taxes.

Out of the woodwork are emerging two groups of people eager to present their solutions to making April 2020, as compared with this April, a little less painful:

1. Real estate agents from Florida and Texas.
2. Those pushing municipal bonds.

I have nothing bad to say about the former, and I am not going to comment about the risks and benefits of relocating to Florida or Texas (I do know that New York spends a lot of money each year checking to be sure that former NY residents have met the required criteria of residency in another state and tracking them down for past taxes where they haven’t).

Rather, I want to address the people pushing municipal bonds and municipal bond funds. I am going to say, quite simply, that my view is that buying these instruments at this time is a terrible idea for all but the extremely wealthy. Here are 2 reasons:

First, most people, especially now, need their liquidity and should not tie up large amounts of cash in a low interest rate environment. One-year municipal bonds - if you can find them – in New York or California have a yield to maturity below 1.40%. Even if you are in a 50% effective tax bracket, that is still a fully tax equivalent return of only 2.80%, and you can still get 2.80% (or better) in a 1-year CD. Unlike municipal bonds, however, you can withdraw your money early from 1-year CDs with a reasonable early withdrawal penalty (BestCashCow recommends that you identify CDs with only three month of interest as such a penalty). As long as you stay within FDIC and NCUA limits, your CDs bear no credit risk. Check online CD rates here. Check local rates at banks here and credit unions here.

Second, municipal bond interest rates are extraordinarily low. You need to go out 30 years to find a municipal bond yielding over 3%. As a point of comparison, I was purchasing high-quality AA New York municipals in 2009 (during the financial crisis) that were seven years in duration and were yielding over 5%. As a general rule, I do not recommend that anyone should buy municipal bonds of more than 5 to 10 years in duration under any circumstance. At the moment, high quality municipal bonds of those durations have tax equivalent yields that, again, do not offer significant premiums over 5-year CDs. They also are extraordinarily risky as they can lose tremendous value (even those of intermediate durations) should long-term rates increase.

Bottom line: Wait until you see higher long-term rates before considering municipal bonds.