Newbie Questions - Individual Muni Bond Vs CD Vs Treasury

daf999999 | Oct 22, 2023 | 13 posts since 2012

Looking to put cash into long-term investment - assume I will not need to touch it for 10 years, don't need any income flow, top fed tax bracket, in IL w/ 4.95 state tax. I value safety and certainty.

5 year CD = APY 4.97;

10 year Treasury via Schwab = YTM 4.91;

9 year IL Gen'l Obligation Bond (A- rating) via Schwab = YTM 4.573; or,

9 year Texas Gen'l Obligation Bond (AAA rating) via Schwab = YTM 4.364.

Looks like tax-equivalent yield on the IL bond is 7.965 and the TX bond is 7.225 and the Treasury is 5.166. Does that look correct?

I understand that there is some credit risk here declining from CD/Treasury to TX to IL - but the returns on, for example, TX seem worth the credit risk - 2% higher.

What am I missing? Also, anybody know whether the coupon payments on the munis are automatically reinvested - or is that a "wild card" I have to account for?

Thanks

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Answers

MAKNYC | Oct 22, 2023 | 323 posts since 2015

One thing to note on the muni bonds….if the bond is a seasoned bond as I suspect it is, and is currently trading at a discount to par, while the YTM quoted is correct, the income will not be totally exempt from taxes hence your tax equivalent yield calculation will be off. Simply stated the part of the YTM calculation that accounts for the closing of the discount over the holding period of the bond (many would assume it would be capital gain) would in fact be fully federally taxable as ordinary income…not tax free, not cap gain. If the muni bonds you cite were new issues or the market discount was a de minimus amount (specifically defined as 1/4 of 1 point per full year left until maturity) then this wouldn’t be an issue. But the facts as you present them suggest neither of those exceptions apply here, and I suspect the coupons on these munis are in the 3%’s hence the taxability of the ‘gain’. And that gain would be taxable as a lump sum at maturity at your marginal tax rate.

The coupon payments on all the investments you cite, unless the CD is a direct CD (not brokered), would be paid to your Schwab account and you would either earn the current .45% or you would have to proactively purchase one of Schwab money market funds.
And if you seek ‘safety and certainty’, personally I wouldn’t touch that IL bond. Don’t take it personally, but your state is not known for its fiscal prudence, and the credit rating expresses that. For the record, I am not all out against any IL bond….I even owned some Chicago Park bonds in the past which at the time were far superior than anything offered at the state level. I have been very, very active in purchasing munis like this myself right now and AA+ and higher can be had for the low to mid 5%’s right now with maturities 2037-2042 (my sweet spot), so lower it a bit to get to your sweet spot. But the same federal tax issue applies. And I live in Texas so state taxes not a consideration.

txFish1 | Oct 22, 2023 | 476 posts since 2023

@MAKNYC. I have also found some Texas school district bonds that have been decent buys lately that are backed by the Permanent School Fund (PSF) which carries a AAA rating. I always thought you were from New York City with your user name being MAKNYC!

MAKNYC | Oct 22, 2023 | 323 posts since 2015

txFish1. Your assumption would certainly seem logical. I spent my whole earlier life in NY, including 1995-2014 in NYC when I worked on Wall Street (industry….not literal). But moved to Dallas in 2015.

txFish1 | Oct 22, 2023 | 476 posts since 2023

Well welcome to Texas. Been here all my life and I'm up in Richardson just north of Dallas

daf999999 | Oct 22, 2023 | 13 posts since 2012

I'm still digesting this but I think its incredibly helpful - and much appreciated. Yes, agree IL is too risky/. I'm now hung-up on "reinvestment risk" as I don't understand how I'm going to be able to get the coupon rate on alternative investments funded by my biannual coupon payment - and, even if I can, it seems like a ton of work to find such an investment 2x/year vs the fund and forget simplicity of a CD.

MAKNYC | Oct 22, 2023 | 323 posts since 2015

There was another thread discussion on this issue a few days ago. Personally I don’t see why this issue should move the needle on going forward with an investment in these. But the solution is to buy a zero coupon bond….treasuries relatively easy, or invest in a direct CD where interest would compound. Or, while not exactly the same, invest in a fund/ETF of bonds in your area of interest. You would avoid the mechanics of it, but retain interest rate risk….which theoretically could work in your favor, although I’m not predicting that.

CuriousDave | Oct 22, 2023 | 233 posts since 2018

Muni bonds that you purchase do not reinvest the interest you earn, so you are subject to reinvestment rate risk over the term of the bonds you select. The problem can be avoided by investing instead in mutual or index funds that specialize in munis issued by IL and/or no-tax states like TX, but of course their fees will reduce your returns.
If you are covered by Medicare, or will become covered during the 10 year term you are proposing, whatever interest income you earn on muni bonds are included In Modified Adjusted Gross Income (MAGI) for purposes of figuring whether you will owe extra premiums under IRMMA, or, if you are already subject to IRMMA, whether you may find yourself in an even higher tier of premium, so you may want to first run your numbers before investing.
Regarding the market discount issue: yes, you will owe tax at your top bracket rate, but, for what it’s worth, you can elect to “accrete” the discount on your annual tax returns rather than picking up the entire discount when you redeem or sell the bonds.

daf999999 | Oct 22, 2023 | 13 posts since 2012

So, I was using an outdated tax equivalent yield calculator. Using an updated calculator (https://www.eatonvance.com/tax-equivalent-yield-calculator.php)

IL = 8.01
TX = 7.65

That makes the spread even greater vs CD or Treasury

njs | Oct 23, 2023 | 71 posts since 2019

I purchased Zero municipals from Zions Direct in 2007. They were all AAA and insured; by 2009 the value had dropped by 40%. By 2019 I had a decent capital gain beyond the tax free interest so I sold them. Just an FYI they are not CDs.

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