The Essentials of Municipal Bonds: Investing in Public Projects

Learn how funding community projects can also help minimize your state and federal tax liability.
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Municipal Bonds: How to Invest Tax-Free in a Community

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What are municipal bonds?

Municipal bonds (“munis”) finance public projects such as roads, bridges, fire departments, libraries and schools. They also offer investors a way to generate tax-free income through interest payments from state and local governments. Municipal bonds are one low-risk strategy for limiting state and federal tax liability, especially for higher-earning investors.

How municipal bonds work

Municipalities issue bonds when they need to raise money for a project. An investor buying a muni bond funds that particular project over a set period. The investor expects to receive interest or coupon payments (usually semiannually) and the initial principal back when the bond matures or the loan term ends. That’s because the higher your tax bracket, the more advantageous muni's tax-exempt benefits are.

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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 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. 

  • 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.

How to invest in municipal bonds

Municipal bonds may be purchased as stand-alone investments or bundles through an online broker. Many robo-advisors also offer munis as part of their portfolio mix.

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 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, you get your principal back when the bond matures. Some muni bonds mature in one to three years, while others mature in 20 or 30. Investors needing regular income might consider buying multiple bonds and building a 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 municipal bonds on their own, investing in munis through mutual funds or exchange-traded funds (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, and varied risk and return. This lessens any potential default risk as you spread your dollars across many bonds.

Another benefit of bond funds is that you are shifting responsibility to a fund manager, who is well-versed in municipal bonds and will monitor the municipalities and related risks for you.

Some investment management companies offer state-specific funds so investors can benefit from federal, 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.

» Ready to invest in munis? Learn more about our best brokers for bonds

Benefits of municipal bonds

As with any investment, it's essential to weigh the pros and cons of municipal bonds before deciding.

Minimizing your tax liability

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 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 taxable brokerage accounts. They put their other less tax-advantaged fixed-income investments in retirement accounts like traditional IRAs and 401(k)s designed to defer taxes.

» Learn more about tax-efficient investing

Diversification

As a general rule of thumb in investing, diversifying your holdings can help 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. A muni bond usually carries slightly more risk and yields a higher return than a Treasury bond but is less risky and will have a lower yield than a corporate bond. Many municipal bonds are also socially responsible investments if the project they finance aims to do some social good or community development.

Adding safety to your portfolio

Municipal bonds are considered a relatively safe fixed-income investment. GO bonds are usually considered safer than revenue bonds, as a municipality can raise taxes to cover outstanding debt obligations. In contrast, 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 municipal bonds

Default risk

While these bonds are a relatively safe investment, 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, munis have an inverse relationship with interest rates. 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 that is 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. This phenomenon is called interest rate risk.

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 bought a new bond at a lower interest rate.

Call risk

Some muni bonds are callable, meaning the issuer can repay the bond earlier than the maturity date. When interest rates fall, an issuer who can call their bond may choose to do so because they can save money by refinancing or reissuing another bond at a lower interest rate.

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