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Interest on municipal bonds remains exempt from taxes — for now

Municipal bond issuers and investors are breathing a sigh of relief following the congressional agreement on taxes and government spending signed into law on Wednesday by President Barack Obama.

The plan does not tinker with the tax-free treatment of interest earned on most debt securities issued by local government entities like states, cities, counties and other municipal agencies.

However, the subject may come up again in a few months when negotiations on the federal debt ceiling resume. But, for the time being, interest earned on municipal bonds remains exempt from federal and state income taxes.

The preferable tax treatment and other factors have made muni bonds a favorite investment for those seeking income.

“Municipal bonds have benefited from the fact they offer higher yields than Treasurys, but still entail relatively low risk of default," said Thalia Meehan, a portfolio manager at Putnam Investments. "As a result, investors have flocked to the asset class, pouring nearly $40 billion into the municipal bond market in 2012, which is among the highest totals in the past 20 years.”

On a pure yield basis, there is little difference between U.S. Treasury obligations and bonds issued by municipal agencies. The average yield on a 30-year Treasury bond is currently 3.14 percent compared to 2.8 percent for a muni with a similar maturity.

On the shorter end of the yield curve, the five-year Treasury note has an anemic yield of just 0.82 percent compared to 0.94 percent in a similar municipal note.

However, when the tax-exempt status in interest from municipal bonds is considered, the after-tax yield favors munis, especially in states like California where income tax rates are significantly higher.

“Tax-exempt munis and taxable bonds once made sense mostly for investors above the 28 percent tax bracket," said Collin Martin, senior research analyst at Charles Schwab. "In our view, this guideline may not hold true as much as it once did. All investors will pay some taxes, so every bit of after-tax yield helps in the current low-rate environment.”

Of course, the new year brings a number of challenges to municipal bond issuers and investors. In particular, California remains mired in an economic crisis that has forced some cities to take drastic actions.

“While the market for municipal bonds generally has been strong this year, a significant negative credit development has been the decision by a number of local governments to address their fiscal challenges by declaring a fiscal emergency or filing for Chapter 9 bankruptcy relief," according to the 2012 Debt Affordability Report issued by state Treasurer Bill Lockyer. "However, while there is a heightened perception of credit risk for California cities, Moody’s said it expects the number of Chapter 9 filing and defaults to remain low.”

The other big risk facing investors is the ultimate possibility of higher interest rates, which would negatively impact the market value of outstanding bond issues regardless of their tax status. Many analysts believe it is simply a matter of when rates start moving higher as the economy recovers.

“We believe that given all that’s going on at the macroeconomic level today, the likelihood of higher interest rates is relatively low," Meehan said. "There is still quite a bit of uncertainty surrounding the sovereign debt situation in Europe, and in the United States the Federal Reserve recently announced a third round of quantitative easing. So ultimately, there are a number of factors applying downward pressure on interest rates.”

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