I’ve talked about bonds before, mostly in reference to their relative safety compared to equities.  It would, however, be a great disservice to lump all bonds together as one.  To give them justice, it’s worth discussing the fact that there are numerous types of bonds, as well as multiple types of bond issuers.  

The two most common bond types in which retirement savers invest are corporate bonds and government bonds.  The latter you may be familiar with if you’ve ever received a US savings bond from, most likely, someone born before 1940.  In this post, I’ll talk about a different type of government-issued bond, the municipal bond, and why it may be relevant to the investment portfolio of a FIRE investor.

Like a corporation, the government issues bonds so that it can raise money to pay for operations and public services.  Different states have different laws governing what a state or municipality (e.g., a county, city or town) can do with bonds – some have to earmark them for something specific, while others have greater flexibility with how they spend funds raised from bonds.  For example, in some locations the government might offer a general bond that funds its overall options, or, alternatively, will issue a new bond specifically to fund the construction and operation of a new firehouse.  You get the idea.

Seemingly a worthwhile investment

A municipal bond is one that is issued by a state or local government, and just like any other bond, pays interest, either in the form of a coupon payment or through original issue discount.  Mechanically they work just like any other bond.

Municipal Bond Risk

The difference, however, is that a municipal bond is essentially backed by the government that issues it.  And this is important, because it means that the bond is fairly secure.  For one, U.S. bankruptcy law does not allow states to file for bankruptcy.  Municipalities like counties and cities are permitted by Chapter 9 of the bankruptcy code to file for bankruptcy; however, it is a fairly rare occurrence.  On average, the number that do so each year is in the single digits.  

Remember that like everything, you have to do some due diligence before you purchase a government bond.  It would be wrong to assume that every single government bond is backed by the full support of the government that issued it.  Some bonds, particularly those to develop specific projects, may be subject to repayment based on the revenues generated by the underlying project that the bond funds.  For example, if a government issues a bond to build a new train system, repayment of the bond may be limited to the revenues generated from the train system.  Keep an eye out for these, because there may be some additional risk involved; however, generally speaking, even these do tend to come with some sort of support by the government agency that reduces their risk – but you have to read the disclosures to determine how much risk you’re truly assuming.

Nonetheless, the chances of default on a municipal bond are relatively low.  That’s not to say they don’t happen – look at Orange County, CA in 1994 and Detroit in 2013, among others, which are some of the most significant municipal defaults on record.

The relatively low likelihood of default means that interest rates on municipal bonds are comparatively low, which is to be expected as they’re a fairly safe (though not perfect) investment.  Much like US savings bonds, which have some of the lowest interest rates in the bond market, you’re unlikely to make a pile of money from municipal bonds, but you can achieve some balance in the risk of your investment portfolio.

Slow and steady

Tax-Exemption

The other aspect of municipal bonds that attracts investors is that they are mostly tax-exempt.  This means that the interest payment you earn on them is not subject to federal taxes.  Nor, in many cases, is the income earned on municipal bonds subject to state income taxes.  

However – and this is critical – municipal bonds are generally only exempt from state income taxes in the state in which they’re issued.  If you live in California, and hold a New York municipal bond, the interest income – though it may be exempt from New York state income tax –  is likely to be subject to California state income tax.  California is not about to give you a break when you’re giving money to another state.  Keep that in mind if you’re shopping around or if you hold municipal bonds and then decide to move.

The tax-exempt nature of most municipal bonds further depresses the return they offer, mostly because municipal governments do not have to pay higher interest given that investors save in taxes.  Think of it this way – if a corporation issues a bond with 10% interest, but the holder will pay 30% of that in taxes, then a municipality can get away with paying 7% interest (all other things equal) because that results in the same return for an investor.  If the municipality were to pay more interest, it’d be overpaying what the market demanded for the risk of the bond.

Municipal Bonds for the FIRE Investor

All things considered, there’s some merit to holding municipal bonds.  Their relative safety and tax-exempt status makes them fairly simple investment vehicles.  While they don’t have as much potential to generate significant returns, they can help you balance the risk of your portfolio.  

Another variable for your projections

For a FIRE investor, achieving a base level of security can be important as you move into retirement.  You may not want to have all of your money in high-risk holdings, just in case there’s an extended downturn in the market.  Of course, you don’t want to play it overly safe either – there’s no need to take a huge hit to your returns, especially because, as history has shown, the market tends to rebound with time.  

Remember that on day one of retirement, you don’t want to switch all your holdings to low-risk assets that generate minimal returns.  If you retire at 45, a significant aspect of having enough money to last until the end of your natural life entails that you continue to produce gains on your holdings, even while in retirement.  What you want to ensure, however, is that you have enough liquidity to survive a short-term shock to the market.  The worst thing you can do is run out of money and have to start working again.

Municipal Bonds and Retirement Accounts

Another consideration to keep in mind is that you don’t want to hold municipal bonds in an IRA or 401(k).  Remember, the money from those accounts is only taxed when you withdraw it.  So if you hold bonds in an IRA or 401(k), none of the interest payments made to the account are taxed. 

Remember, in the example above, the corporate bond pays higher interest to account for the fact that its investors need that higher interest to offset the taxes they’ll pay. But if you’re not paying taxes on the interest payments, you’re losing money by holding a non-taxable bond at 7% over an otherwise taxable bond at 10%.  For the same amount of risk, you can reap the entire 10% interest because you’re not subject to the tax on the gain.

Conclusion

In sum, if you’re saving for retirement, or you’re in retirement, municipal bonds can be a viable option if you take advantage of the tax exemption and use them to balance risk. However, a FIRE investor probably doesn’t want to hold too much in municipal bonds due to their generally lower returns.

Like any other investment you make, make sure you understand exactly what you’re buying, including the risk of the bond, whether it’s tax-exempt to you, and that you hold the bond in the right account.