Which of the two is the better investment option for your portfolio? To discover the answer to that question, you must calculate something known as the taxable-equivalent yield. Generally speaking, the lower your tax bracket, the more favorable corporate bonds will be as an investment, whereas the higher your tax bracket, the more favorable municipal bonds appear.
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One trap you should avoid is the habit new investors seem to pick up that causes them to reflexively put tax-free municipal bonds in retirement plans that are shielded from taxes due to their inherent structure. Even if you are in the highest tax bracket levied in the United States, the income within your k plan or other retirement accounts is already shielded from the IRS, making corporate bond yields a better choice from a taxation perspective in most situations.
A handy rule to keep in mind is that opposites attract: Taxable bonds go into tax-free accounts, and tax-free bonds go in taxable accounts. Depending upon the duration of the municipal bonds you hold in your investment portfolio, your assets may fluctuate more or less than stocks. All things come with a price—hence the economic maxim, "There is no such thing as a free lunch.
That is the trade-off you must make. Rare situations occur every few decades when this is not true.
This is known as an inverted yield curve. When you buy a municipal bond in the primary market, your money is lent to a local or state government for projects that make life better for the average person. If you buy bonds issued by a school district, your money will probably be used to construct a new school or gymnasium. If you buy a municipal bond issued by your hometown, the money may be used to construct roads, bridges, hospitals, sewage plants, and other public works.
The Cost of Inefficient Coupons on Municipal Bonds on JSTOR
Instead, most folks invest in municipal bonds through a bond fund. By the way, my colleague Brett Owens recently recommended 4 muni-bond funds he likes now. You can read all about them here. Your typical fund will have over municipal bonds in its portfolio. For that reason, muni investors tend to rely on IPOs a lot more than stock investors do.
Bond brokers and underwriters offer the best bonds to their biggest clients—or keep them for themselves.
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That means regular investors are often left with the scraps. Interest rates are a big concern with municipal bonds because of something known as convexity.
The higher the convexity, the more a bond will go down when rates rise. Fears of higher rates caused muni bonds to crater in late Because the market has realized it overreacted.
But the dividends these funds provide are still only around 2. The 2.