The Allure Of Zero Coupon Municipal Bonds: Low Risk, Decent Yields

Zero coupon municipal bonds are a type of low-risk investment you should consider for the low-risk portion of your net worth. I've personally built a decent municipal bond portfolio to help generate more tax-efficient passive income.

If you buy your own state's municipal bond, you won't have to pay state or local income taxes. Nor do you have to pay federal income taxes. Therefore, if you are in a high federal income tax bracket and live in a high state income tax state, municipal bonds are relatively more attractive.

In this post I'd like to do the following:

  • Explain how to read a bond offering table, including municipal bonds
  • Discuss the differences between a regular municipal bond and a zero coupon municipal bond
  • Highlight who should consider buying zero coupon municipal bonds

With high interest rates, municipal bonds, treasury bonds, and corporate bonds are all looking much more attractive. As a result, building a bond portfolio now is a more attractive value proposition.

Municipal Bond Portfolio 2024 And Beyond

I will be adding to my municipal bond portfolio due to higher interest rates. As someone without a day job, I like having a steady stream of low-risk, tax-efficient income given I life in California.

I'm also buying Treasury bonds yielding over 5%. With Treasury bonds, you don't have to pay state or local income taxes either. With one-year Treasury bond yields at the highest since 2007, they are too attractive to pass up.

Further, it's always nice to protect massive gains since the bottom fell out in February 2009. As a retiree, cash flow is more important than net worth. It is the cash flow I need to stay retired and pay for our family's living expenses.

When it comes to generating passive income, building a municipal bond portfolio is one way to do it. For those of you who are in a high federal income tax bracket, municipal bonds should be the most attractive.

Reading A Municipal Bond Offer Chart

After sending an e-mail about my financial goals to my wealth manager, he sent me a list of specific California municipal bonds for me to consider. There's a lot to digest, so let me first explain each column and then highlight two examples.

Municipal Bonds Spreadsheet Offering

CUSIP: CUSIP stands for Committee on Uniform Securities Identification Procedures. A CUSIP number identifies most financial instruments, including stocks of all registered U.S. and Canadian companies, commercial paper, and U.S. government and municipal bonds.

Offer Quantity: The figures are usually in 1,000's. In other words, 315 = 315,000 shares.

Issue: The description of the bond

Coupon: The yield at the beginning of the offering. A coupon of 5 means $5, or a 5% yield on $100 par.

Maturity: When the bond matures, stops paying a coupon and when you can get your principal back.

Moody rating: Moody is a rating agency for securities. The higher the rating, the lower the chance of default.

S&P rating: S&P is also a rating agency for securities.

First call: When the bond issuer can get back their money before maturity. If the first call is the same as maturity, there is no first call. Issuers may want to have a first call just in case interest rates go down so they can reissue at a lower rate.

Call price: If there is a first call, then the price stated is what you'll get back. $100 is the default issue price.

Offer price: Where the bond is trading now if you want to buy it. For the Agoura Hills bond issued at $100 X amount of years ago, you can buy it today for $121.566.

Offer yield: The coupon divided by the current offer price minus any loss you would get after holding to maturity.

Current yield: The coupon divided by the current offer price.

Offer Yield To Maturity (YTM): The annualized yield you would get if you held to maturity. YTM is also called Yield To Worst (YTW) if the bond is callable.

Historical Municipal Bond Performance In Rising Interest Rate Cycle

Example #1: Agoura Hills, Regular Municipal Bond

If you wanted to buy one Agoura Hills bond, it would cost you $121.566 per share. You would get a $5 coupon every year double taxation free (no federal income tax, no state income tax), for a yield of 4.11% ($5 / $121.566). Sounds good. If you decide to hold the bond until maturity, 6/1/2025, you will only get $100 of the $121.566 you invested back. Sounds bad. Therefore, your yield to maturity is really only about 2.2% once you account for the $21.566 loss.

Why would anybody want to buy such a bond? Nobody says you have to hold on to the bond until maturity. It is quite possible to collect a 4.11% double taxation free yield for one year and sell the bond at $121.566 or even higher if interest rates come back down. In other words, the principal value of a bond changes before maturity and there is a secondary market by which you can buy and sell your shares as noted in the Offer Quantity column.

Bond Investors Must Forecast Interest Rate Direction

As a bond investor, you are basically taking a view of where interest rates are going along the yield curve and the issuer's ability to pay the money promised.

If you're buying a muni bond, you've already decided that you want to invest on the lower end of the bond risk spectrum since default rates for munis are very low (see chart below). Within muni bonds, you can further select the highest rated bonds for even less risk.

A 2.2% yield to maturity for the Agoura Hills bond isn't very attractive. I want a yield that's at least above the 10-year yield, even though I don't have to pay taxes on the 2.2% yield. Psychologically, it also feels bad to pay $121.566 for a bond when it was issued at $100, albeit it years ago.

So what's the solution? A zero coupon bond.

Example #2: La Mesa Spring Valley California School District GO, Zero Coupon Bond

The La Mesa bond is a zero coupon bond that pays no coupon i.e. no income each year. In exchange, you can buy one La Mesa bond for only $73.573, a $26.427 discount to par value. When it matures on 8/1/2026, you get $100 for each share you buy, which comes out to a yield to maturity of 3.2%. The La Mesa bond is also a general obligation bond backed by taxes, which is safer than a revenue bond backed by the performance of the asset e.g. train fares.

A 3.2% yield to maturity is 1% higher than the Agoura Hills 2.2% yield to maturity. But be aware the La Mesa Bond matures one year later than the Agoura Hills bond. Given time is money, it's only logical for a longer term bond to pay a higher yield. Further, since you can't collect any coupon payments, you aren't able to reinvest the money for potentially greater gains.

So who would buy a zero coupon municipal bond on the secondary market that doesn't mature for almost 10 years and pays no interest? Me! And maybe even you.

Here's my profile that argues why buying zero coupon bonds in an overall bond portfolio is attractive:

  • High federal income tax bracket (32% – 37%)
  • Living in a high income tax state (10.3% – 12.8%)
  • Total federal + state marginal income tax rate = 40%+
  • State taxes will continue to go higher because California is a blue state
  • Don't plan to die within the next 10 years
  • Plan to continue being in a high tax bracket for the rest of my life
  • Plan to keep California as my home base for at least 10 years
2023 Federal income tax brackets

Investing For The Long Run

Based on my history of investing, I LOVE locking money away for 5 – 10 years at a time. I've done so with my private equity investments, venture debt investments, CDs and all real estate holdings.

The longer I'm invested in a particular asset, the more I tend to make. I dislike seeing the daily/weekly principal value fluctuations, which sometimes tempt me to sell too soon or buy too early. I'd rather spend a lot of time researching a particular investment, deploying capital and forgetting all about it until the money comes due.

My time is best spent making money via my business. I shouldn't try to time the market and pick investments. Give me a 5% gross annual gain each year and I'll be happy. My annual business income yield is multiple times greater.

Zero coupon bonds are more attractive than regular bonds due to a higher yield to maturity. If you can afford to not earn a coupon, then you may come out ahead if you hold until the end.

Just know that if you have to sell municipal bonds, you may have to take a large discount. The muni bond market is relatively illiquid, so the bid / ask spreads are wide.

One thing to note is that there may be a long term capital gains tax on the profits you make from your zero coupon municipal bond depending on what price you bought it compared the the original issue discount price. Here's an article that explains the tax consequences further.

Bond Credit Quality Rating Chart

Below is a great chart that highlights the three different rating agencies and the way they rank investments. Given every retiree's #1 objective is to not lose principal, I'm mostly focused on buying municipal bonds with a credit rating of A, Aa, Aaa, AA, and AAA. Just be aware that even credit agencies can get things wrong too.

Bond Credit Quality Ratings Chart

Municipal Bond Default Rates

Municipal Bond Default Rates By Rating And Type

The default rate for A-rated municipal bonds is only 0.05%. By the time you get to Aaa, the top rated Moody's municipal bonds, the default rate drops to 0%.

It's up to you to decide how much risk you want to take. Studying the chart makes me comfortable buying some Baa rated municipal bonds in the portfolio with a 0.32% default rate in order to get a higher yield.

Zero Coupon Municipal Bond Offers

Here's the final snapshot after filtering out the best zero coupon municipal bond offerings from the main spreadsheet. The Folsom Cordova and Anaheim bonds look attractive, but I'd have to lock my money up for 13-14 years instead of my sweet spot range of 5-10 years.

Zero Coupon Bond Chart

The solution to investment uncertainty is to build a bond ladder just in case interest rates continue to rise. For example, if I invested $10,000 in each of the five zero coupon bond offerings above, I'll receive $13,591, $14,102, $14,760, $15,608, $16,588 in 2026, 2027, 2028, 2029, and 2030, respectively.

Build A Municipal Bond Ladder With Different Durations

If interest rates rise, I'll just buy more zero coupon bonds with higher YTMs in a ladder fashion again. All I've got to do is “survive” from now until 2026. Of course I will because I've got passive income and business income that's pretty sticky.

A total investment of $50,000 will turn into $74,649 by 2030. This assumes I don't reinvest a dime of the earlier maturing bonds. A $24,649 return ($24,649 / $50,000) is a respectable return, and even higher, tax adjusted. Not bad for a relatively low risk investment. It's very comforting to know exactly what you'll be getting in the future.

All these zero coupon yield to maturities were 0.5% – 0.85% lower right before the presidential election. It's the same for most zero coupon bonds. That's a nice $5,000 – $8,500 a year lift in tax free income on a $1,000,000 position. All five YTMs are also greater than my 2.375% and 2.5% mortgages as well. This doesn't even take into consideration the tax benefits.

It feels amazing to finally be able to build a double taxation free municipal bond portfolio now that yields are higher. Take advantage of higher interest rates by earning higher interest income.

Below is a bond yield table from Fidelity that highlights all different types of bonds by duration. The table updates every day. Toward the bottom, you can see three types of Municipals by investment grade. The higher the investment grade, the lower the yield. Usually, the longer the duration, the higher the yield.

U.S. bond yields

Bonds Plus Investing With Real Estate

In addition to investing in bonds and municipal bonds, consider investing in real estate too. I consider real estate to be a type of bonds plus investing given the greater potential upside.

The combination of rising rents and rising capital values is a very powerful wealth-builder. In 2016, I started diversifying into heartland real estate to take advantage of lower valuations and higher cap rates. I did so by investing $810,000 with real estate crowdfunding platforms.

Best Private Real Estate Investing Platforms

Fundrise: A way for all investors to diversify into real estate through private funds with just $10. Fundrise has been around since 2012 and manages over $3.3 billion for 400,000+ investors. 

The real estate platform invests primarily in residential and industrial properties in the Sunbelt, where valuations are cheaper and yields are higher. The spreading out of America is a long-term demographic trend. For most people, investing in a diversified fund is the way to go. 

CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations and higher rental yields. These cities also have higher growth potential due to job growth and demographic trends. 

If you are a real estate enthusiast with more time, you can build your own diversified real estate portfolio with CrowdStreet. However, before investing in each deal, make sure to do extensive due diligence on each sponsor. Understanding each sponsor's track record and experience is vital.


I've invested $810,000 in real estate crowdfunding so far. My goal is to diversify my expensive SF real estate holdings and earn more 100% passive income. I plan to continue dollar-cost investing into private real estate for the next decade.

Recommendation To Build Wealth

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75 thoughts on “The Allure Of Zero Coupon Municipal Bonds: Low Risk, Decent Yields”

  1. I bought a zero coupon muni a few years ago for around $60 a share and now it’s around $85 a share. I’ll be moving to California at the start of next year. When the muni maturity ends at $100 a share, will I have to pay California state tax on the entire $40 profit, or just the $15 part that happens after I move there?

  2. I am assisting a family with their investments. I have been asked by the father (85 years old) to purchase bonds in a taxable account, that his daughter can inherit. Due to his age and current health, we can reasonably assume any bond that matures in more than 10 years from now will do so after the father has passed.

    My goal is to maximize yield for them, without assuming unreasonable default risk, in a way that produces no taxes for the daughter. Since she will be able to use the step up in basis, I think any bond that defers tax liability until maturity would produce the desired result for them. If I am correct, what type of bond can I buy that will have this trait?

      1. Will this type of bond result in zero taxation for the family or will they owe taxes on the profit from this? My goal is to make sure they owe no taxes at any point.

        1. Financial Samurai

          You’ll pay federal income taxes for Treasuries.

          Munis purchased of your state are double tax free.

  3. Very Interesting Article, I’d like to know how you find the zero coupon bond information, do you utilize a broker? Any books you would suggest? I’m in Oregon so I’m interested in zero coupon muni’s there.

    Thank you

  4. Sam, random question. Where do you get the images for your blog? How do you ensure images are in the public domain? Thinking of starting my own blog.

  5. Hi Sam-

    I may have missed this or it may be a topic you’re planning on covering soon, but what are your thoughts on the markets direction? This will be 8 straight + years and seems like we are due for a downturn. I am relatively young and all the conventional wisdom says to stay in equities but I’m getting concerned. Perhaps not the worst time to go into some bonds?

    1. Hi David, nobody really knows how long the good times will last. Politicians have proven in the past did not deliver on their promises. Therefore, it seems likely that the market is getting ahead of itself with regards to what Trump is planning regarding corporate tax cuts, Government spending, etc.

      I know there is one certainty, and that is you can never lose if you lock in a gain.

      I suggest reading my recommended asset allocation post and following a specific investment cadence.

  6. I started my zero coupon muni bond ladder in 1997 when I got a large insurance payment. I put the bond portion of my portfolio all into individual bonds rather than a fund. I aimed the ladder to start “paying out” in 2007 (earliest eligibility for pension). Every couple of years I refill the ladder. I haven’t gone out further than 11-12 years (mostly aim for 10).

    It’s worked well for me since I have never been forced to take money out of the stock portion of my portfolio.

  7. Thanks for another excellent clarification post. Would you recommend that individuals begin buying bonds as they approach FI so that they have the cash on hand to begin building up the safer investments? I guess I don’t understand precisely when the growth stage ends and the maintenance stage should begin.

    1. No problem. Take a look at my most, The Proper Mix Of Stocks And Bonds By Age, to get an idea of how bonds fit in to an overall investment portfolio. There are many choices I’ve given for people to decide.

      The worst year for bonds was -2.9% since 1989, and the default rates for municipal bonds are extremely low. These two facts should prove attractive for those who want less volatility, more assurances, and more income.

      The growth stage ends when you’ve accumulated a large enough financial nut where you can live off for the rest of your life at a reasonable withdrawal rate: 1% – 4%, depending on the size of your nut and expenses. Once you’ve got that nut, then it’s all about PROTECTING YOUR NUT AT ALL COSTS. It’s easy to forget about downturns after a 8 year bull market. But lose 50%, and it takes 100% to just get back to even.

      I’m in the stage now where all I want is a ~4% low risk rate of return on my mothership nut. If my passive income can naturally organically jump from $200,000 one year to $208,000 the next year, I’m ecstatic b/c I spend less than that already.

  8. Very solid article, but three points in addition to BK’s which are spot on.

    1) Zero coupons don’t have higher YTMs as a class of bonds – i’m not sure if that was picked up anecdotally by looking at the bond offering table or some other way, but I just don’t believe that’s accurate – It’s a slightly different calculation, but as an issuer, I’m agnostic about whether I issue a two year, zero coupon bond for 96 that matures at par ~2.06% yield; or issue a straight bond with a 2.06% coupon (probably could have done whole numbers but you get the picture)

    2) Zero coupon bonds do introduce more duration risk (i.e. they fall in value more as interest rates rise). If you feel that this is a threat, then zero coupon bonds are less attractive at the margin (because of the reinvestment ability that BK listed in straight (coupon-paying) bonds as interest rates rise – conversely, no reinvestment risk if yields fall.)

    3) Buying individual bonds is a relatively inefficient and less liquid venture than say buying individual stocks for instance, unless you have some real size. I’d say the vast majority of your readers would be better off buying a fund because transaction costs will eat you alive (assuming you’re not an expert trader with great access – mitigated somewhat if you’re buying and holding)


  9. Hey Sam,

    Long time reader, First time poster. You really caught my interest with this piece, since I work on the FI desk for a large retail firm.

    As usual, you’ve done a great amount of research, and with the time-frame you are looking at, going into BBB/Baa isn’t a bad idea. From your posts, I know you have been investing in bond funds, and will probably invest in Zero’s. With a previous comment being made about not liking to see losses, you will see quite a few paper losses in a “rising rate” environment. As long as that doesn’t fool you into selling before maturity, Zero’s are great investments.

    One suggestion I’ve made to a couple Cali clients is to look at national muni’s. Demand far exceeds current supply, and you can pick up enough yield to cover state taxes and get another 10-15 bps on top of that (Texas, Florida, Ohio, etc.)

  10. Is there any concern that the CA pension crisis could affect future bond payments? I would imagine that there must be some sort if firewall between physical infrastructure and state/municipal pensions, but given the next Education Secretary’s penchant for charter schools, it might be wise to steer clear of school issues.

    Interesting link on CA pensions below- state pensions now at $1 trillion.

    1. There’s always a risk. In a bull market where municipalities are flush with cash due to tax revenue and operating revenue from the facilities, the chances of default are even smaller than the table above.

      We’re talking ~0.34% default rate for Baa muni bonds.

      The irony is that in a bull, bull market, the high yield bonds have done very well b/c the thought is they provide higher yield and their chance of default has gone down further. They’ve outperformed muni bonds tremendously since the election, hence the opportunity in munis imo.

  11. Geez, these things seem complicated.

    So if you were to buy that bond that WAS $100 at $121, is that because the bond issuer did an early call or is a bond always on the market like a stock? Like, if I were to issue the Angry Retail Banker Municipal Bond (because I’m a city now) today and it was a $100,000 bond because that’s how much I need to raise, it would be divvied up into XYZ number shares selling at, say, $100/share? And as people buy more shares, it would drive up the share price? And I as the issuer would set the yield and this the sell price at maturity? I guess that’s the only way a bond can be listed with a sell price lower than the purchasing price.

    Wait, is the La Mesa bond simply a $100 bond that’s currently selling at $70 due to people selling? Is a $100 bond always $100 in the end, and someone who buys at that price getting absolutely nothing if there’s no coupon? Or is it like savings bonds where EE bonds are sold at half the face value and redeemed at face if held to maturity.

    Sorry for the interrogation. I love to learn not just how investments work but WHAT they are and what exactly is going on when you invest in something.

    ARB–Angry Retail Banker

    1. It’s great to have a learning mentality.

      Zero coupon bonds have to be priced below the $100 par value because they pay zero coupons. If not, nobody would buy it. The Yield To Maturity calculates the yield AS IF it was paying a coupon and an investor buys at the original issue discount (OID) and holds to maturity.

      Bonds have traditionally gone up in value by 2% – 5% a year, hence why you see a $121 price for the Agoura Hills bond issued years ago. For a total return, take the principal value increase + coupon payment. Let’s say Agoura Hills goes up in principal value by 2% in 2017 and provides a 2.2% yield, that’s a 4.2% total return.

      This should answer people’s questions on why buy a regular bond instead of a zero coupon bond. A regular bond has a chance to increase in principal value (or decline) + receive a coupon. A zero coupon is locking in your upside if held to maturity.

      1. I grasp why a zero coupon bond would provide more value than a coupon payer. I grasp total return too. I just don’t understand how they fluctuate in value like that. I understand how a STOCK can fluctuate, but not a bond.

        My confusion comes from the fact that your article seems to indicate that a bond’s initial sell price and the redemption value at maturity are preset. If that’s the case, how are the prices fluctuating? The presence of an early call indicates to me that a bond isn’t liquid like a stock, or else why would there be a need for such thing? It sounds more like a CD, but based off loaning money to a municipality.

        It’s just dawning on me now that while a bond issued might have a preset initial sell price and maturity value, it might change hands and someone buying a 5 year bond 4 years in would pay more because they only have to wait 1 year before maturity. An early call sounds like the bond issuer (the borrower) refining their “loan” at a lower rate.

        Okay, NOW am I getting the technical details of how bonds work? I think I might have just walked myself through it. I like to know how things work.

        ARB–Angry Retail Banker

        1. A lot of the fluctuation has to do with the expectation of inflation, growth and interest rates. The other consideration is the credit worthiness of the borrower, which is why munis getting hit harder than higher yield bonds is the opportunity imo. But as with all investments, I leg in with multiple tranches. I plan to build a muni bond portfolio over the next three years so long as my income is in the 33% federal income tax bracket.

  12. I haven’t bought any bonds directly before so I don’t have any experience with zero coupon bonds. Lots of great insights above so I can see the appeal. I have bought some muni ETFs this year though.

  13. 1) is great website put out by the Municipal Securities Rulemaking Board and has lots of information (trade data, official statement, research, etc.

    2)Generally speaking, zero coupon bonds are best utilized when interest rates are high, so that one can lock in higher yields and avoid re-investment risk. With nominal rates still low, unless you don’t think they are going to go any higher, you want some reinvestment risk. If you buy a ladder now with no intention of selling before maturity, and interest rates rise, you will be missing out on “buying” more income until the bond matures. Think about this from a mortgage perspective. Imagine if mortgage rates fell 2% in 2 years. Would you wait until 2026 to re-finance?

    3)In the context of all munis being relatively “safe” nothing says a General Obligation bond is safer than a revenue bond. Recent credit issues have been skewed towards G.O. (Stockton, Valllejo, Detroit, MI, Harrisburg, PA, Puerto Rico, even going back to Orange County).

    4)Muni Insurance trades as worthless in the market. There are no more AAA rated monoline insurers after the financial crisis. Less than 7% of bond issuance last year even had an insurance wrapper.

    4)The gains (or losses) on municipal bonds are in fact taxed at the capital gains tax rates. Only the income is federally and potentially state tax free.

    1. Great stuff BK! Thanks for clarifying. What’s your background?

      I’ve added clarification on the taxation issue and linked to this post which further clarifies the tax situation on zero coupon municipal bonds:

      3) Interesting thoughts on GO and the real examples given. But wouldn’t it make sense that depending on a train’s ticket revenue maybe be riskier than depending on people to pay their taxes overall all? A train system could stop working due to an explosion, natural disaster, terrorist attack. But if that stuff happened, people would still pay their taxes.

      2) On building a bond ladder, it’s not just building a bond ladder with various durations, it’s ALSO building a bond ladder in multiple tranches. In my case, I like to buy 5 tranches of a position over a 3-6 month period of time once I believe there is value in a particular asset. I don’t think the 10-year bond yield will break 3%. If it does, we are either screwed or in a raging bull market, which is fine for stocks and real estate.


      1. I’ve been working for a boutique asset management firm for 13 years, where ~2/3rds of the assets are municipal bonds.

        The vast majority of revenue for a Local G.O. (small city/town) comes from property taxes. (The remainder is generally state pass through – which in tough times gets cut quickly). I agree the risk is relatively minor comparatively, but look at how many people are moving out of Chicago as they dramatically raise property taxes to deal with their budget deficits. NJ/CT also have negative population growth. Puerto Rico is the ultimate example of this. A Toll Road authority could have full rate setting authority and simply raise the toll. And look what happens where there is an unfortunate tragedy, like the recent train systems in NY. The state steps in rebuilds/fixes immediately so there is less lost revenue. Interest coverage ratio and days cash on hand are important metrics for revenue bonds.

        Multiple tranches makes sense. Stay flexible. Many bond investors just buy and hold and do nothing until their bond comes due. After the Taper Tantrum, yields skyrocketed to over 3% in the Summer of 2013. But, they were only there for a brief period. If a passive investor didn’t have any bonds come due, they missed out on that opportunity to lock in higher yields.

        Another popular use of Zero Coupon bonds is to fund college tuition. Buy a bond that comes due during your child’s freshman year, then sophomore, etc. Similar to asset/liability matching.

        1. Good tip on timing the maturity for college.

          How are you guys investing after the sell off? Any worried clients? How high do you guys think the 10 year will go in the short term?

          I just don’t see the 10y go above 3%.

          1. Yes, clients are worried. There is sticker shock when they see bond prices down so much so quickly. Clients can see their equities down significantly and feel OK, but, if their bonds are down just a bit they get very nervous. Even though most bonds have a baseline of par at maturity as a worst case scenario. Seeking to lock in higher yields/extend maturity when rates rise like this.

            My personal opinion is 3% seems like a long way from here. I think a big wild card is how much foreign governments have to dump UST to support their currency as dollar rises.

            1. Very interesting. Hopefully your clients will have the appetite to buy more with higher yields. If we go to 3% on the 10Y, I surely hope it is a RAGING bull market where real estate and stocks are on fire.

              Given the 10Y yield is so much higher than foreign yields, I would think foreigners would find our assets more attractive. The Chinese mainland buyer of the $2.25M home this spring in SF, which has been empty for months is sitting pretty.

              At the end of the day, the muni market is only down about 3.8% from the recent peak, so that’s not that bad, is it?

  14. Great read, loved this article and the way you made these bond concepts easy to understand. With interest rates being so low for many years investors have turned to high risk/high yield bonds to get a better rate of return. The junk bond market in the US is roughly 1.3 trillion currently. Do you feel investors of these bonds could get wiped out if we see a downturn in the economic because they have such poor credit ratings?

  15. Only zero munis have no income tax each year, correct?. I believe typical taxable zero’s you have to pay phantom tax on the coupons every yr even through you didnt collect anything

  16. Hi Sam,

    Absolutely wonderful analysis! One question though. How do you buy individual bonds, meaning who do you send the check to?

    Thanks, Bill

    1. Adam and Jane


      I used to buy individual muni bonds from a “financial advisor” at a bank BUT I learned that they cost a min of $2 more per bond. For example, a bond at Fidelity may cost $100 but the same bond at a bank may cost $102. I opened a Fidelity brokerage acct online two years ago. Set up a link from your bank’s checking acct to Fidelity’s brokerage acct on the Fidelity site and transfer funds electronically. I now buy bonds on my own to save money. No more human interaction to transfer money or to buy bonds. I have total control of my bond portfolio! If you live in a tax free state like Florida then you can buy muni bonds from any state.


  17. Great article Sam. We are in CA and fall under the 39% fedral tax bracket so we are seriously looking into bonds. New to this investing so have learnt a lot from the article.

  18. Great article Sam, as always. A few questions for you:

    1. In a previous post, you mentioned looking for muni bonds that can throw off interest payments equal to your mortgage payment to effectively live for free. Does the zero coupon approach change that since you won’t receive interest payment along the way?

    2. Regular, non-muni, zeroes require you to declare the accrued interest in a calendar year as income and therefore potentially pay taxes on it. Since munis are double tax free, is this a non effort or do you still need to file info on zero munis but just with a $0 in taxable interest?

    3. How do you plan to account for the zero munis increase in value over time in your net worth calculation? Current price times # of shares/bonds or something else?

    Thanks again for a great article and in advance for any answers to my questions.

  19. Can you maybe talk about how this plays into your taxes? Pretty new to this and I don’t feel like you covered the benefits for taxes enoigh.

    1. Sure. You don’t pay taxes on the income you make from municipal bonds. The higher your marginal federal and state income taxes are, the more attractive municipal bonds are.

      You may pay long term capital gains taxes on any profits you make on the municipal bond principal amount.

      For Zero Coupon Muni Bonds, the same applies, but it’s tricky. It depends on how long you hold and at what price you bought compared to the original issue discount.

      Here’s a better article that explains it:

      1. Why is it a double tax free return? Is this a reference to federal AND state taxes? Also, at what combined tax rate would you consider to be the lowest rate where this would make sense? 28%, 33%, 40%?

        For someone with a 15-year mortgage at a low interest rate (assume 2.6%) but a high marginal tax rate, it seems fairly smart to put the final 5 years of into a 10 year bond, rather than make a large principal payment this December?


        1. Yes. Federal and state. I’ll clarify this in my post further. 28% and higher probably makes sense.

          10-year bond is offering a ~2.38% taxable yield versus 2.2% non taxable yield in the Agoura Hills example. If you have a 28% federal + 8% state tax = 36% marginal tax rate, the 2.2% = 3.43% gross yield. Given A and higher muni bonds have an extremely low default rate, I’d rather buy a muni than a 10-year bond.

  20. Thanks for a great post. We’ve started to struggle to stay out of certain marginal tax brackets too (what a great problem to have!). Can you explain how these double taxation free bonds help with keeping your income within a certain marginal tax bracket? Or offset the risk of being in these higher tax brackets?

    1. Sure. Let’s say you have $200,000 in passive income as an individual, with $60,000 in itemized deductions. Your taxable income is now $140,000, leaving you about even under Trump’s proposed income tax plan (not paying 33% marginal tax).

      Every dollar you invest has the potential to generate MORE passive income, putting you in a higher income tax bracket. Instead of buying assets that produce income which are then taxed, you can buy a growth stock (higher risk) or a zero coupon municipal bond (lower risk) to produce zero income only until sale or maturity.

      Nobody knows the future, but you can try and manage your future income streams.

      1. Okay. Got it. We are not lowering our tax burden in the current year, but are potentially lowering it in future years. Thanks.

  21. Adam and Jane

    Sam, as you suggested I am posting my comment on muni bonds here from your prior post “Best Ways To Maximize Your Financial Advisor”.

    Excellent overview munis!

    My co-worker told me about zero coupon bonds in 2008-2009 but I was not interested because I wanted interest payments through out the year and not just when the bond matures. We needed passive income to cover monthly expenses in case I had to quit due to a bad re-org or get laid off. We started in 2009 and each year we purchase more until we reached FI in 2014 when it generate 66K tax free.

    Our muni bond portfolio consist of mainly 4% to 5% bonds. In 2016, it will generate 84.5K triple tax free and in 2017 it will generate 86.6K. Our overall yearly yield for our individual bonds combined is around 4.45% triple tax free.

    We are so fortunate to have these munis generate income because my wife just got laid off in Nov 2016 and we are financially OK. We have NO financial stress due to her loss of income because we were prepared incase both of us would get laid off. Many of our co-workers are in panic mode because they did not prepare to lose their jobs. Many had no savings or passive income.

    I can only suggest that people generate any forms of passive income from munis, dividents, rental income, etc ASAP to prepare for a raining day. Dont wait until you need to act.

    Here are my “regular” Muni bonds criterias

    1. Ratings is extremely important. I tend to avoid investment grade which is a B. I look for bonds that are rated a min of upper med grade (single A).

    Best quality – AAA
    High Quality – AA
    Upper Med Grade – A

    See this site for the ratings chart –

    2. Buy what you know.

    I like MTA (mass transit), water, Dorm Authorities for schools and hospitals. Make sure the school and hospitals are well know. People will always need these facilities. Bonds will vary from state to state so buy what you know in your state.

    3. I only buy Revenue Bonds. I avoid GO (General Obligation) bonds. With revenue bonds, municipalities can increase revenues to pay back bond holders.

    I started out buying GO bonds because they were backed by taxes. Many thought that GO bonds were safe too until issues in Detriot and Puerto Rico. As a result, I now buy REV bonds. To be on the safe side, one can buy a mixture of GO and REV bonds but it comes down to financial stability of your state.

    4. Tax exemption. Make sure it is totally tax free. Check the bond details.

    Federally taxable – NO
    Subject to AMT – NO

    5. Insured

    If a muni bond is insured then the bond is safer. Insured bond are tough to find and they are usually a bit more expensive.

    6. YTW (Yield To Worst or Yield To Call) greater than 4%. In a 33% tax bracket, it is like a 6% CD.

    YTW is the min the bond will earn when a bond is called. Most bonds are callable after 10 years of being issued so I dont really pay attention to maturity date. Bond prices are currently dropping so I like to buy bonds in x amounts. Dont spend all your money on just one bond. Currently, I can easily buy a 4% bond below PAR. I am hoping to get 4.5% YTW next and then a 5% YTW bonds in the near future. In the end, just be happy with the yield of the bond purchased and dont go crazy if the bond price drops. If you hold the bond until it is called or matures then you will get the face value back to avoid lost of principle except for the premium paid.

    I like to sort all the munis for my state with YTW in descending order which will display the highest yield at the top of the list. This makes it easier to select a bond.

    7. Call dates, mature dates and month interest is paid.

    You can buy bonds with different call dates and maturity dates to create a bond ladder. This way your bonds will return your principle at different years so that all of your money is not locked to a specifc year.

    I also look for bonds to pay on different months of the year so that I will get bond payment every month. This is not a show stopper but it is nice to get payments every month.

    8. Price of the bond.

    Try to buy bonds at face value of $100 (PAR) or less. If you have to pay a premium then pay at most 1-2 dollars. For example, a 4% bond at $102 will take 6 months to break even. When this bond is called or matures, only the face value is returned to you. If you paid a premium then it will result in a lost of principle. This is not a big deal if especially you are happy with the yield and the interest you received


    1. Adam,

      You have a similar philosophy as my late father who only invested on bonds after being burned by stocks. He too always bought bonds to the longest maturity because in his experience, they often were called early. Hard to know if that will continue now that interest rates are so low.

  22. Great article and analysis. One of my favorites since I learned a lot from this. I need to try and buy some bonds to put this into practice.

    I have a question: why would a bond issuer want to call a zero coupon bond early? I do see the call price listed so I guess it’s a calculation for them to call early and pay a bit below par (100)?


    1. Hi Mike,

      To answer you question, it’s always great to put yourself in the shoes of the issuer.

      If I was paying a $5 coupon and a 5% yield on the initial par value of $100, I would love to call the bond earlier if I see interest rates drop, allowing my to only pay a $3 coupon and a 5% yield, for example.

      Now that interest rates have risen, the likelihood of a bond being called early DECREASES b/c the issuer would have to RAISE the coupon to stay competitive in raising money.

      This is the reason why mortgage holders should NOT pay down their principal as aggressively anymore.

      Hope this makes sense.


      1. Sam,

        Thanks. I was asking specifically for calling a zero coupon bond early. There is no coupon so what is the benefit for the issuer to call it early?

        1. Hi Mike. It is the same thought process. You would call the bond early because you see interest rates go down. You have an obligation to pay it back eventually, and if you need to raise more money you can call back earlier and re-issue at a lower YTM.

      2. Hi Sam,

        Would you say the same for paying down student loans principal in this rising interest rate environment?

  23. Great overview! At this point in my financial journey, I probably wouldn’t buy zero coupon bonds. I’ll be close to the high federal income tax bracket, but I’d still like the extra cash flow from the coupon payments.

    I agree that general obligation bonds are safer than revenue bonds. However, I think if you have knowledge of the area/asset, someone can probably take advantage of the spread difference.


    Thanks for this very thorough post. I must admit my knowledge about bonds, especially municipal bonds, is very limited. This really helped me to understand the benefits and drawbacks of investing in municipal bonds. I am a CA resident about to be in the 33% tax bracket (if Trump’s plan passes) so anything I can do to reduce taxes is great. This gives me a whole new investment vehicle to consider!

  25. The Green Swan

    Not something discussed a ton on the blog and boards, but thanks for changing that! Another way to invest and diversify. I haven’t done much research myself into this realm so thanks for the recap.

  26. just a thought

    Thanks for starting to focus on these investment types. Not everything needs to be about high flying tech stocks or real estate.

    Since I am in a state with no state income tax, I prefer the higher yield muni funds.

  27. Sam, I’ve been a regular reader for years, LOVE your stuff.

    Question: I’ve been moving into Vanguard’s VWITZ muni fund (~$50k thus far), would LOVE your thoughts on it. Easier for me than buying individual bonds, still get tax benefit (I’m a high marginal tax guy). Would I be better served buying individual issues?

    1. rabbithutch

      I second this question — similar situation (regular reader and high tax rate)! I have quite a bit in VWITX and like the idea of a municipal bond FUND rather than buying individual bonds. What is the downside to this, if any?

      1. Anne-Marie Wood

        I’m looking at VWAHX High Yield Tax Exempt municipal bond fund and am wondering if this is a good option as well.

    2. Hola Fritz – Thanks for the kudos.

      I’ve been building a position in CMF and MUB as they’ve fallen. They are muni bond portfolios to just gain exposure. I plan to allocate ~70% of my muni bond money to these two bond funds.

      With the rest of the 20%, I plan to buy individual California muni bonds that offer higher yields and yields to maturity to juice up the return.

      If you look at the default chart, the default rates are next to 0%, and actually 0% for AAA rated muni bond funds. Hence, if I can find a higher YTM than what the bond fund is providing, I’m willing to buy individual bonds with a higher yield given such a low risk.

      A lot of people buy funds b/c they don’t have the time or knowledge or researching desire to pick their own. But with a 0.05% default rate for an A rated muni bond fund, a financial advisor who can screen the names for you, and a desire to write 1,500+ word posts to analyze what I plan to buy with the help of a community, I figure why not pick some of my own.

      We are operating in the lowest end of the risk curve here, unlike folks who are pumping and dumping penny stocks!


  28. Sorry, not a business person. I still can’t understand why a zero coupon muni is better than a non-zero one, everything else being equal ?

    1. It’s b/c all else isn’t equal. If held to maturity, many zero coupon bonds have a higher yield than non-zero coupon bonds. Check out the first spreadsheet and notice the Current YTM column. The lowest YTMs are regular muni bonds.

      If you can afford NOT to get paid a coupon each year, you should get a higher return on average at maturity. But many people either like the annual income, want the annual income, or can’t afford not to have the annual income.

      1. Ah, okay. So if I take the coupon and invest it, and count that, then the yield would be higher. But I got you now. Thanks for the explanation.

        1. @Bihn & Financial Samurai: this above statement is WRONG. The stated yield of a couponed bond assumes immediate reinvestment of the coupons at the original stated yield. Reinvesting the coupon does NOT “increase” the yield.

          The beauty of a zero coupon is that you buy the bond at the present value of the cashflows *AS IF YOU DO* reinvest the coupon immediately, upon payment, every 6 months. In a couponed bond, the investor never realizes the stated yield, bc they would need to find an investment with the same (remaining) term and return as the original bond & yield, every 6months, which is not plausible.

          In a couponed bond, the total return on the invested dollars over the life of the bond is always more or less than the original stated yield, because the coupons wind up being invested (or not) elsewhere.

          Also, regarding the yield being higher for a zero-couponed bond, that’s bc the DURATION is more for a zero. It’s more interest rate risk for a given stated maturity.

      2. There are more than just one reason for the higher yields on zero-coupon bonds than coupon bonds. One is because there are no interim cash flow payments, so the zero-coupon bonds have a longer duration for two bonds with the same maturity. Therefore if more of the proceeds are with the borrower for a longer period of time, there is a greater risk of default and a longer present value of money impact.

        1. True. But I’ll take my chances given the default rates are extremely low. I’m building a diversified muni bond portfolio where so far zero coupon munis are only taking up 10% of the muni bond portfolio.

  29. I finished my comment and then thought of one piece of advice directly for you. Always buy munis as if your holding to maturity. Their liquidity tends to be on the lower end of the scale so you can get eaten alive by the spread.

  30. Go Finance Yourself!

    Interesting post, Sam. Very few bonds in my portfolio as I’m looking for growth. I like the idea of the bond ladder to protect against rising interest rates. What is the market like for zero coupon bonds? Is there much activity making it easier to sell, or would they be hard to get out of?

  31. Thanks for the great tutorial on muni bonds. I haven’t invested in them and this post is really helpful.
    My main question – isn’t the rate still pretty low? I guess if you’re looking to lock in 4% gain, it’d be an easy buy. You still foresee interest being low in the next 5-10 years?

    1. Everything is relative. With most of my mortgage at 2.5% or lower, locking in a 5%+ gross yield is extremely attractive. I think most people have refinanced their mortgages or gotten a new mortgage at 4.25% or less.

      As a retiree, I’m focused on principal protection and ~4% – 5% total net worth growth. But these bonds are a minority percentage of my current investments.

  32. I still hold some municipal bonds for CT, but given my income is zero since I FIRED I don’t have as much reason to buy them as you. I can keep my bond allocations in tax advantages retirment accounts.

    Is there a reason you want to buy individual bonds vs investing in something like VCITX. You pay a little in fees but would get a spread over a lot more different bonds. And looks like the performance has been close to 5%.

    Thanks for the in depth break down, interesting stuff!

    1. Thanks for highlighting VCITX for California residents. Will take a look further! There are endless investment choices to make and research.

      I never thought my income would reach a top income tax bracket in early retirement. Seriously, I thought I’d just live off my passive income of ~$80,000 back in 2012, live frugally in Hawaii, and be done w/ trying to build wealth. But after 5 more years of writing 3X a week, things just continued to grow.

      Now, I’m considering capping passive income by diversifying into zero coupon munis b/c now that I think of it, I’m not so sure I’ll still by writing 3X a week or still have FS 10-13 years from now. That would be a 18-21 year run!

      1. Not on topic, but the day you shutter FS will be a terrible day.

        On topic – you reference “double tax free” several times. What does that mean?

  33. Sam, this was a great primer on zero coupon municipal bonds. I haven’t seen such thorough a discussion since b-school!

    None in my portfolio right now, but this is good to keep in mind when I switch over to capital preservation mode in a few years.

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