25 JUNE 2025

By Raul Elizalde

This article also appeared on forbes.com

Municipal bonds (“munis”) are fixed-income instruments issued by local governments., typically to finance the construction of public projects. While not all munis are tax-exempt, most are, meaning their interest is generally free from federal and, often, state income taxes. Because of this, their nominal yields are not directly comparable to those of taxable bonds.

To make a fair comparison, investors should look at after-tax yields. Since bond interest is taxed at ordinary income rates, the most common approach is to calculate the “tax-equivalent yield” of a muni bond by dividing its yield by (1 – tax rate). The higher your tax bracket, the more attractive munis appear. For instance, a 2.5% tax-exempt yield equals a 3.85% taxable yield for someone in the 35% bracket but just 3.21% for someone in the 22% bracket.

For investors in the highest tax brackets, muni yields can be especially appealing. Currently, 5-year AAA-rated munis offer a tax-equivalent yield close to 6% (for a 35% tax rate), well above the 3.6% yield on a comparable U.S. Treasury. At first glance, this looks like a clear advantage.

Risk #1: Call features

However, many munis are callable, meaning they can be redeemed early by the issuer. Because this is not uncommon, investors should also consider the “yield to worst” (YTW), which reflects the lowest possible yield if the bond is called early. This yield is typically lower, because the bond skips future interest payments that would have otherwise been received. In that case, the issuer has an incentive to cathe bond early.

Risk #2: Lack of liquidity

Some investors seek higher yields by buying lower-rated munis, which typically offer better compensation for added credit risk. This strategy has long drawn investors to the muni market. Lower-quality munis current trade at tax-equivalent yields of 6-7%, significantly above comparable Treasuries. But munis are notoriously illiquid: only about 1% of all municipal bonds trade on a given day. This can make them difficult both to sell and to value—what is the price of a bond that doesn’t trade?

Risk #3: Obscure pricing

Bonds that do not trade still get a price every day, but those prices do not reflect market activity. Rather, they are supplied by pricing services that rely on comparisons with other similar bonds. The risks of this theoretical pricing were highlighted by this summer’s collapse of the Easterly RocMuni High Income Fund. Managed by two professional fixed-income portfolio managers who were also Chartered Financial Analysts (CFAs), the fund lost 50% of its value in just two days as redemptions forced it to sell unrated, high-yield munis with deteriorating credit quality at steep discounts. If professional managers can be caught off guard, retail investors must be extremely cautious.

To manage liquidity risk, a good practice for investors is to buy munis they are willing to hold to maturity, making secondary-market pricing irrelevant. Maintaining an average rating of A or higher can help limit credit risk, and monitoring changes to that credit rating is a must. Favoring non-callable bonds can ensure the stated yield is achieved. Finally, even with attractive after-tax yields, muni exposure should remain a manageable portion of a portfolio. Concentrating too heavily in illiquid assets can backfire if cash is needed unexpectedly. The extra yield may not be worth sacrificing the ability to sell holdings at a fair price when needed.

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