Question

Explain why most retired individuals are not likely to be heavily invested in municipal bonds and why these types of bonds would not be held in an IRA (individual retirement account).

Answer 1

Municipal bonds are considered their own asset class and sometimes they do not act in unison with the taxable bond market. If investors see an opportunity for bond price appreciation or favorable tax-equivalent yields, than owning muni bonds may make sense.

The more popular exception to owning municipal bonds in an IRA is when the municipal bond is taxable. A taxable municipal bond is usually issued by a local government, such as a city or county, to finance a project or activity that does not provide a major benefit to the public. Typically, these taxable issues offer a much higher rate than their tax-free counterpart, since the tax-free incentive is no longer available.

Reason why Retired InIividuals don't invest in municipal bonds

Bond Yields May Not Beat Inflation. If you’re not investing in municipal bonds for current income, but instead for long-term tax-advantaged growth, you’ll want to consider how your bond investment will hold up to inflation. Because municipal bonds are often a conservative investment and they also offer tax advantages, their yields tend to be relatively low. Therefore, they are less likely to beat inflation than many other investments, such as stocks. This means the money you have parked in a bond fund could be worth less in buying power a few years from now than it is today.

Opportunity Cost. If you decide to invest in municipal bonds, take a good look at the equation above or visit one of the many online calculators that will calculate your taxable equivalent yield. Running this calculation is essential to ensure that municipal bonds make more sense for you than a taxable bond investment. If you are in a low tax bracket, for example, you won’t be able to capitalize on the tax advantages of a municipal bond as much as someone in a high tax bracket. Moreover, you may give up the opportunity to realize the higher return on a comparable taxable bond if you invest in a municipal bond instead.

Interest Rate Risk. When interest rates go up, current bonds lose value. This is because bonds that carry a lower interest rate must be sold at a discount to equal current bond yields. This is less of a concern if you plan to hold the bonds to maturity, but it can still be a difficult pill to swallow if you have to cash out bonds or bond funds when they are trading at less than face value.

Risk of Default and Loss of Capital. Any investment carries risk. Municipal bonds are no different. Although historically, it’s been rare, there’s always the chance the municipality could go belly up, in which case your interest payments and principal would be lost.