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Today we’re going to talk about municipal bonds—what they are, when they make sense, and how to use them in a retirement-focused portfolio.
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Why High-Net-Worth Investors Should Care About Muni Bonds
When clients ask me, “Do muni bonds make sense for me?” I always remind them that every investment should serve a clear purpose. For individual investors, the primary role for both taxable or municipal bonds is reducing the overall volatility of your portfolio.
But unlike most bonds, municipal bonds typically pay interest that is exempt from federal income taxes, and in some cases, exempt from state income taxes if you live in the issuing state.
So comparing munis to corporate bonds or Treasuries requires calculating the tax-equivalent yield (TEY).
How to Calculate Tax-Equivalent Yield (TEY)
The easiest way to see whether a muni makes sense is by comparing it to the after-tax return of a taxable bond. That’s where the tax-equivalent yield (TEY) comes in.
The formula is simple: TEY = Muni Yield ÷ (1 – (Federal Tax Rate + State Tax Rate + NIIT, if applicable))
Let’s walk through an example:
Suppose you’re looking at a municipal bond yielding 4%. If you’re in the top federal bracket — 37% for married couples filing jointly in 2025 — plus the 3.8% Net Investment Income Tax, your total federal rate is 40.8%.
Now apply the formula:
- TEY = 4% ÷ (1 – 0.408)
- TEY = 4% ÷ 0.592
- TEY = 6.8%
That means a 4% muni is just as attractive as a 6.8% taxable bond for someone in the top federal bracket.
What Happens When You Add State Taxes
Keeping with our 4% muni example, the benefit grows once you account for state income taxes, and it’s meaningful in both the top and second-highest brackets.
Top Federal Bracket (37% + 3.8% NIIT = 40.8% federal)
- California (13.3% state tax): Total = 54.1% → TEY ≈ 8.7%
- New York (10.9% state tax): Total = 51.7% → TEY ≈ 8.3%
- Florida (no state tax): Total = 40.8% → TEY ≈ 6.8%
Second-Highest Federal Bracket (32% + 3.8% NIIT = 35.8% federal)
- California (13.3% state tax): Total = 49.1% → TEY ≈ 7.9%
- New York (10.9% state tax): Total = 46.7% → TEY ≈ 7.5%
- Florida (no state tax): Total = 35.8% → TEY ≈ 6.2%
That’s your tax-equivalent yield. It won’t be perfect down to the decimal, but it’s a quick way to see whether munis give you an edge over taxable bonds.
How Municipal Bonds Work: General Obligation vs. Revenue Bonds
Beyond the tax benefit, another reason investors find munis attractive is credit quality. Roughly 70% of the muni market is rated AA or AAA, and defaults are historically rare compared to corporate bonds.
Moody’s data shows the 10-year cumulative default rate for investment-grade munis is about 0.1%, compared to 2.2% for investment-grade corporates.
So while defaults aren’t unheard of, the muni market overall is widely considered to be one of the lowest risk areas of fixed income.
High-yield and non-rated munis, however, carry notably higher default risk. This sector of the muni market includes bonds financing speculative or thinly traded projects like charter schools, senior-living facilities, or a local entertainment venue—many of which lack institutional investor interest.
So where you see them is in individual investor portfolios. In fact, whenever I review a prospective client’s portfolio at Plancorp that holds individual bonds, they usually have an uncomfortably large number of high-yield, state-or-local only issuances. And I suppose that’s not a surprise because brokers earn more selling them; and investors agree to them because of the high yields and the familiar narrative of investing locally.
This is probably the biggest mistake I see investors making with municipal. But a close second is investors favoring state-specific muni bonds.
Why I Don’t Favor State-Specific Muni Funds
At this point, many investors say: “Why not just buy munis from my home state and get the extra tax break at the state level?”
It’s a fair question — and yes, if you’re a California resident buying California bonds, you may avoid both federal and state taxes on your interest. The math looks attractive. But here’s why I usually advise against it:
- Reduced diversification. By sticking only to your state, you concentrate risk in one economy, one political system, one pension system, and even one climate profile. A wildfire in California, a budget shortfall in Illinois, or a hurricane in Florida can all impact local credits. With a national muni portfolio, you spread that risk across states and sectors.
- Fewer opportunities to enhance returns. Anytime you shrink your opportunity set, you give up the chance to find higher-yielding or more attractively priced bonds elsewhere. A national portfolio opens the door to more issuers and structures, which can improve both diversification and expected returns.
- The market already prices in much of the tax benefit. Research shows that strong in-state demand often pushes local muni yields lower. In other words, much of the state tax advantage gets “competed away” because residents bid up the prices. You still get some benefit, but not as much as the headline tax-equivalent math suggests. The trade-off is that you end up more concentrated and less diversified.
To me, the takeaway is clear: a national muni allocation may give up a sliver of state tax savings, but you gain broader diversification and access to a larger opportunity set. That can be the difference between a narrowly tax-optimized portfolio and one that’s truly resilient.
How to Implement Muni Bonds in a Portfolio
When it comes to adding munis to a portfolio, one of the first decisions is whether to buy individual bonds or use a mutual fund or ETF.
Individual Bonds: Certainty, But With Trade-Offs
With an individual bond, you know exactly what you own. You know the issuer, the coupon, the maturity date, and—barring default—you know what you’ll get back. That certainty appeals to many investors, and it helps some people look past price swings along the way.
But the trade-offs are real:
- You need a large amount of capital to build a diversified muni portfolio.
- Transaction costs are higher, and prices less transparent.
- You take on idiosyncratic issuer risk, where one bad bond can do meaningful damage.
See EP.97: Individual Bonds vs Bond Funds
Funds and ETFs: Diversification and Professional Oversight
For most high-net-worth investors, bond funds or ETFs are the more effective solution. With a single purchase, you get exposure to hundreds—sometimes thousands—of different muni issuers.
Benefits include:
- Instant diversification across states, sectors, and maturities.
- Professional credit monitoring, with dedicated analysts reviewing issuers.
- Lower trading costs and more efficient access to the muni market.
Yes, a fund’s daily price will fluctuate, which some investors dislike for the “safe” part of their portfolio. But in practice, the benefits of diversification and professional oversight far outweigh the discomfort of seeing prices move.
Plancorp’s Approach to Using Munis
At Plancorp, we typically only use muni bonds for investors in the top two federal tax brackets (32% and 37%), because that’s where the tax-exempt income truly changes the math.
Even then, we don’t build portfolios that are 100% munis. The reason is the same logic we apply when avoiding state-specific funds: anytime you shrink your opportunity set, you give up chances to enhance after-tax returns and improve diversification. By combining munis with other fixed income types—like Treasuries, corporates, or securitized bonds—we preserve a larger opportunity set and make portfolios more resilient.
Why We Prefer Actively Managed Muni Funds
When it comes to implementation, we also lean toward actively managed muni funds rather than passive index trackers.
Here’s why:
- Bond indexes aren’t like stock indexes. In stocks, the index weights companies by market cap, which tells you something meaningful about investor consensus. In bonds, index weights are based on the amount of debt outstanding. That means the most indebted issuers end up being the largest positions in an index—not necessarily the safest or most attractive.
- Liquidity matters in the muni market. Many individual muni issues trade infrequently. Skilled active managers can navigate these liquidity gaps, while index funds are often forced to buy or sell bonds at inopportune times.
- Credit analysis still adds value. With thousands of issuers and a wide range of structures, an active approach lets managers avoid troubled credits and pursue bonds with more favorable risk/reward trade-offs.
See EP.99: The Problem With Investing in Bond Indexes
In other words, active management in munis helps mitigate some of the structural flaws of bond indexes, while still delivering broad diversification and professional oversight.
Implementation in Practice
So whether you implement through individual bonds, funds, or ETFs, the principles remain the same:
- Focus on investment-grade credit quality.
- Diversify across a broad national pool of issuers.
- Avoid concentrating 100% of your bond allocation in munis.
- Favor actively managed strategies that can sidestep the pitfalls of bond indexing.
The Muni Market Outlook
Once you know how to implement muni exposure, the next logical question is: “What does the market look like today?”
Why Munis Have Underperformed Recently
So far this year, munis have lagged other parts of the bond market. The primary reason is heavy issuance—cities and states have been flooding the market with new bonds.
- Higher construction and project costs have pushed municipalities to raise more money.
- Many issuers rushed to market ahead of potential federal tax law changes that could affect muni exemptions.
As with any market, when supply rises faster than demand, prices weaken. That’s why broad muni benchmarks are roughly flat, while the broader U.S. Aggregate Bond Index has posted stronger gains.
The Silver Lining: Attractive Yields
The good news is that yields are now at some of their most attractive levels in the past decade.
- A 20-year AAA-rated muni currently yields about 4.3%.
- For investors in the top federal bracket, that translates into a tax-equivalent yield of roughly 7.2%.
That’s especially compelling when you compare munis to Treasuries or corporates of similar quality.
Muni-to-Treasury Ratio: Relative Value Still Matters
Another lens we use is the muni-to-Treasury ratio (sometimes called the “MOB spread”). This ratio compares the yield of a muni bond to a U.S. Treasury of the same maturity, before adjusting for taxes.
- Right now, 30-year munis yield about 94% of Treasuries.
- After factoring in the tax exemption, that tilts strongly in favor of munis.
This kind of relative value analysis helps us judge whether munis are fairly priced, expensive, or attractive compared to other fixed income options.
Credit Quality: Still Strong, But Past the Peak
Overall, muni credit quality remains strong. Most states and municipalities are in better financial shape than a decade ago. But we may have passed the peak in credit strength:
- Ratings agencies have recently issued more downgrades than upgrades—the first time since the pandemic.
- Economically sensitive issuers—like small hospitals, certain higher-ed institutions, or areas prone to natural disasters—may face headwinds if the economy slows or federal aid programs shift.
The key takeaway: defaults remain rare, but credit selectivity matters, which is another reason we lean on active management and broad national exposure.
Why This Outlook Still Matters Beyond Today
Even though I’ve shared today’s numbers, the themes here are timeless:
- Supply and demand drive short-term muni performance.
- Relative value (vs. Treasuries and corporates) is always a useful yardstick.
- Bonds play a role that cash simply can’t replicate—locking in yields, offering upside potential, and diversifying stock-heavy portfolios.
That’s why we don’t try to time the muni market, and we don’t abandon bonds for cash just because yields are temporarily close. Instead, we build portfolios designed to take advantage of the enduring strengths of munis: tax efficiency, diversification, and long-term income.
Key Takeaways: How Municipal Bonds Strengthen a Retirement Portfolio
If you take one thing from today’s blog post, let it be this: municipal bonds can be a powerful tool for high-income investors planning for retirement—but only when you use them thoughtfully. Look at tax-equivalent yield, stick with investment-grade credit, and favor broad national exposure rather than concentrating in a single state or chasing eye-catching yields in non-rated issues. For most investors, well-chosen funds—ideally active—are the most efficient way to get there.
Remember, bonds aren’t just a placeholder for cash. They help lock in income, add the potential for price appreciation if rates fall, and provide diversification that smooths the ride of an equity-heavy portfolio.
If you want more on this topic and early looks at my new book, The Perfect Portfolio, you can join the email list at theperfectportfoliobook.com. You’ll get excerpts, behind-the-scenes updates, and invitations to subscriber-only webinars.
Resources:
- Get sneak peeks of my new book at theperfectportfoliobook.com
- See EP.99: The Problem With Investing in Bond Indexes
- See EP.97: Individual Bonds vs Bond Funds
The Long Term Investor audio is edited by the team at The Podcast Consultant
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