Municipal Bonds: How to Invest Tax-Free in a Community

When buying municipal bonds, investors loan money to a community to fund infrastructure and build public works. Muni bonds are popular investments since they are relatively safe and can help investors save on taxes.

Tiffany Lam-BalfourNovember 11, 2020
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Municipal Bonds: How to Invest Tax-Free in a Community

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As you drive down a smooth highway or past that new, state-of-the-art stadium, you might wonder how your city paid for it. It’s very likely a municipal bond made it happen.

Municipal bonds, also known as munis, are debt securities issued by state and local governments to bankroll necessary infrastructure. They're often used to build hospitals and roads, to improve schools or to kick off public works projects.

Muni bonds also are popular among investors. They can generate regular income and typically are exempt from federal taxes, as well as most state and local taxes, making them particularly attractive to those in higher tax brackets.

How muni bonds work

Municipalities issue a bond when they need to raise money for a project. An investor buying a muni bond is funding that particular project over a set period of time. They expect to receive interest or coupon payments (usually semiannually) and the initial principal back when the bond matures, or when the loan term ends.

» Learn more about bonds and how they work

There are two main types of muni bonds, and they differ by where they get the money to pay investors.

A general obligation bond, or GO bond, is typically backed by a municipality's local government, with an unconditional promise of repayment. It might pay its investors from a general fund or through a dedicated local tax.

A revenue bond uses the money generated by the 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.

Sometimes a municipality issues a revenue bond on behalf of a private entity, such as a university, housing developers or health systems. These are called conduit bonds. In these cases, the conduit borrower has the ultimate responsibility of covering the debt obligations.

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Should you consider muni bonds?

As with any investment, it's important to weigh the pros and cons of municipal bonds before jumping in.

Benefits of muni bonds

Tax minimization: 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 as well. This especially benefits investors in a higher tax bracket, as the tax exemption enhances the bond’s return.

You might see a calculation for a tax-free municipal bond’s tax-equivalent yield, or TEY, which helps investors compare a muni bond’s return with that of a taxable bond. Here's how that calculation works:

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 calculation would go 4 / (1 - 0.35), and 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 they purchase tax-free muni bonds can save investors money. For example, many investors in higher tax brackets strategically buy tax-exempt munis in their brokerage accounts, which are taxable. They put their other less tax-advantaged fixed-income investments in retirement accounts like traditional IRAs and 401(k)s that are designed to defer taxes.

Diversification: When it comes to investing, it makes sense to not put all your eggs in one basket and instead diversify your holdings. This helps minimize investment risk across your portfolio. Investors often use muni bonds alongside Treasurys, corporate bonds and other fixed-income securities since they all have different risk and reward profiles. Usually, a muni bond carries slightly more risk and will have a higher yield than a Treasury, but is less risky and will have a lower yield than a corporate bond.

Many municipal bonds can also be considered socially responsible investments if the project they finance aims to do some social good or community development.

» Check out more details on diversification

Safety: Municipal bonds are considered a relatively safe fixed-income investment. Looking at data from research firm Moody’s, between 2007 and 2016 the cumulative default rate for investment-grade muni bonds averaged 0.18%, compared to investment-grade corporate bonds' average of 1.74%.

GO bonds are usually considered safer than revenue bonds, as a municipality can raise taxes to cover outstanding debt obligations, whereas revenue bonds are subject to the earnings made by that particular project. Revenue bonds also can be “nonrecourse,” meaning investors would be left high and dry if project revenues don’t meet expectations.

Risks of muni bonds

Default risk: While these bonds are a relatively safe investment, municipalities can 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: Similar to other fixed-income counterparts, muni bonds generally have an inverse relationship with interest rates. So if interest rates go up, bond prices come down, and vice versa.

If you purchase a bond and later interest rates rise, you are locked into receiving a return less than what you would receive by buying a new bond at the higher interest rate. Thus, the price or market value of your bond falls as your bond is worth less. On the flip side, if you purchase a bond and later interest rates drop, the price of your bond rises since you’ve locked in a higher return than if you purchased a new bond at the lower interest rate.

Call risk: Some muni bonds are callable, which means the issuer can decide to repay the bond earlier than the maturity date. When interest rates fall, an issuer with the ability to call their bond may choose to do so because the issuer can save money by refinancing or reissuing another bond at a lower interest rate.

How to invest in municipal bonds

The capital market for muni bonds has grown over time, reaching a whopping $3.9 trillion in 2019. If you think they have a place in your portfolio, there are a few ways to get started. You can buy individual muni bonds or muni funds in your online brokerage account, and many robo-advisors offer munis as part of their portfolio mix.

Individual bonds: Many investors purchasing muni bonds have a buy-and-hold strategy, intending to hang on to them until maturity. These investors can research and select bonds that work best for their portfolio in terms of risk and return, maturity date and tax benefits.

Municipal bond ladders: When you purchase an individual bond and hold it, you don't get your principal back until the bond matures. Some muni bonds mature in one to three years, while others mature in 20 or 30 years. Investors needing regular income might consider buying multiple bonds and building a ladder, with bonds maturing annually or in whatever time increment that fits their situation and cash flow needs.

Muni funds: For those who might not feel comfortable picking municipal bonds on their own, investing in munis through mutual funds or exchange-traded funds, also known as ETFs, can make sense. One benefit is accessing a well-diversified portfolio of bonds from municipalities with different credit ratings, a range of projects and bond types (GO or revenue), and varied risk and return. This lessens any potential default risk as you spread your dollars across many bonds.

Another benefit is shifting the onus to someone else well-versed in municipal bonds, namely the fund manager, to keep tabs on the municipalities and related risks for you.

Some investment management companies offer state-specific funds so investors can benefit from both federal tax exemption as well as state and local tax exemption. Even if you can’t find a state-specific muni fund that works for you, a national fund can provide federal tax exemption at a minimum.

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