Municipal Bonds: Basics, Pros and Cons and How to Invest
Learn how funding community projects can also help minimize your state and federal tax liability.
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What are municipal bonds?
Municipal bonds (“munis”) are debt instruments that state and local governments sell to investors in order to finance public projects such as roads, bridges, fire departments, libraries and schools. They offer investors a way to generate tax-free income through interest payments from state and local governments. Municipal bonds are one relatively low-risk strategy for tax-efficient investing, especially for people in high tax brackets.
How municipal bonds work
Municipalities issue bonds when they need to raise money for a project. Investors who buy these bonds receive interest or coupon payments (usually semiannually) and the initial principal back when the bond matures or the loan term ends.
Types of muni bonds
The three main types of muni bonds differ in how the money is raised to pay investors and who is responsible for the debt obligation.
General obligation bond: A municipality's local government backs general obligation bonds (GO bonds) with an unconditional promise of repayment. It might pay its investors from a general fund or through a dedicated local tax.
Revenue bond: A revenue bond uses the money generated by a specific project to fulfill its debt obligations. Examples include a bridge or tunnel that collects tolls or a stadium using ticket sales to pay interest and principal back to investors.
Conduit bonds: When a municipality issues a revenue bond on behalf of a private entity, such as a university, housing developers or health system, these are called conduit bonds. In these cases, the conduit borrower is ultimately responsible for covering debt obligations.
Pros and cons of investing in municipal bonds
Less taxes.
Diversification.
Risk mitigation.
Default risk.
Interest rate risk.
Call risk.
Advantages of municipal bonds
Less taxes
Many municipal bonds are exempt from federal taxes, and if the investor lives in the same state where the bond is issued, the muni will often be exempt from state and local taxes, too. This primarily benefits investors in higher tax brackets, as the tax exemption enhances the bond’s return.
A tax-free municipal bond’s tax-equivalent yield, or TEY, helps investors compare a muni bond’s return with that of a taxable bond. The formula for tax-equivalent yield is:
TEY = tax-free municipal bond yield / (1 - investor’s current marginal tax rate)
For example, if an investor in the 35% tax bracket buys a tax-free muni bond yielding 4%, the bond’s TEY would be 6.15%. An investor would need to find a taxable bond yielding 6.15% to be comparable to this muni bond.
Being thoughtful about where you purchase tax-free muni bonds can save money. For example, investors in higher tax brackets may strategically buy tax-exempt munis in their taxable investment accounts. They may put their other less tax-advantaged fixed-income investments in retirement accounts such as traditional IRAs and 401(k)s, which are designed to defer taxes.
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Diversification
Diversifying your holdings can help minimize investment risk across your portfolio. Muni bonds, Treasurys, corporate bonds and other fixed-income securities all have different risk and reward profiles. A muni bond usually carries slightly more risk and yields a higher return than a Treasury bond but is typically less risky and often has a lower yield than a corporate bond. Many municipal bonds are also socially responsible investments, meaning the project they finance aims to do some social good or community development.
Risk mitigation
GO bonds typically carry less risk than revenue bonds, because the issuer has the power to raise taxes if it needs cash to cover the debt obligations.
In contrast, revenue bonds rely on the earnings from the particular project they finance. Revenue bonds also can be “nonrecourse,” meaning investors may be left high and dry if the project doesn’t generate enough cash to make the interest and principal payments on the bonds.
Risks of municipal bonds
Default risk
Municipalities sometimes find themselves in financial hot water. You might recall headlines about defaults in Detroit in 2014 and Puerto Rico in 2018.
Such defaults are rare, and you can combat default risk by researching the municipality and reviewing the credit rating for the bond you’re interested in. Credit rating companies such as Moody’s, S&P and Fitch assign ratings to help investors evaluate the riskiness of each bond. Additionally, the Municipal Securities Rulemaking Board, a regulatory body, maintains a website with disclosure documents, pricing data and other information valuable for muni bond investors.
Interest rate risk
Like other bonds, muni bond values have an inverse relationship with interest rates. If interest rates go up, bond prices go down, and vice versa.
If you purchase a bond and then market interest rates rise, you are locked into receiving a return that is less than what you would receive by buying a new bond with a higher coupon rate. Thus, the market value of your bond falls. This phenomenon is called interest rate risk.
On the flip side, if you purchase a bond and then interest rates drop, the price of your bond rises since you’ve locked in a higher return than if you bought a new bond at a lower interest rate.
Call risk
Some muni bonds are callable, meaning the issuer can repay the bond before the maturity date. When interest rates are falling, the issuer may want to call the bond because they can save money by refinancing or reissuing another bond at a lower interest rate.
How to invest in municipal bonds
Municipal bonds may be purchased as stand-alone investments or bundles through an online broker. A good financial advisor can help you choose the bonds that are right for your goals, portfolio and tax situation.
Individual bonds
Some investors purchasing muni bonds have a buy-and-hold strategy, intending to hang on to them until maturity. These investors can research and select specific bonds that work best for their portfolio in terms of risk and return, maturity date and tax benefits.
Municipal bond ladders
When you purchase and hold an individual bond, your goal is to get your principal back when the bond matures. Some muni bonds mature in one to three years; others may mature in 20 or 30. Investors who want to build a stream of regular income might consider buying multiple bonds and building a bond ladder, with bonds maturing annually or at whatever time increment fits their situation and cash flow needs.
Muni funds
For those who feel uncomfortable picking specific municipal bonds, investing in munis through mutual funds or exchange-traded funds (ETFs) can make sense. This helps create a diversified portfolio of bonds from municipalities with different credit ratings, projects and bond types, as well as varied risk and return. This lessens any potential default risk as you spread your dollars across many bonds.
Another benefit of investing in bond funds is that bond funds have fund managers who are well-versed in municipal bonds and will monitor the municipalities and related risks for you.
Some state-specific bond funds can help investors benefit from federal, state and local tax exemptions on the interest income. Even if you can’t find a state-specific muni fund that works for you, a national fund may at least provide a federal tax exemption.
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