joe daniel price/Getty Images
There’s more to diversifying your income than just lowering your overall investment risk. Adding different types of investments, like municipal bonds, is a great way to utilize assets that provide tax-advantaged income.
What makes these types of bonds worth owning is that the interest they pay out to investors is not subject to federal taxes, making their returns more attractive. In some cases city and state taxes are also exempt. Whether muni bonds make sense for you depends on your income, investment goals and risk appetite.
What are municipal bonds?
Municipal bonds are securities issued by local governments, such as a city, state, county or municipality. When you buy a “muni” bond, you’ll get an interest payout about twice a year and then get your principal, or initial investment, paid back to you on the bond’s maturity date.
A city might use the funds to finance things such as a new bridge or highway. The maturity of a muni bonds typically ranges from one to 10 years.
Interest payments from muni bonds aren’t subject to federal taxes. And If the bonds are issued by the state or city in which the investor resides, they’re also free of state and local taxes.
Types of municipal bonds
There are a couple of different types of muni bonds, including:
- General obligation (GO). These are issued by the government and allow the government entity to tax residents in order to pay back the bondholder. Some GOs are from general funds or backed by dedicated taxes, but they aren’t backed by revenues from a specific project.
- Revenue. These types of bonds are backed by a specific type of project or source. There are a lot of different types of revenue bonds, like those coming from colleges and hospitals, for example.
Pros and cons of municipal bonds
| Pros | Cons |
|---|
| Tax-exempt from federal tax and possibly state and local tax | The bond price could fall |
| Low volatility | Not inflation-friendly |
| Minimal default risk | Still a chance of default |
Pros
- Tax-exempt. Muni bonds are usually exempt from federal taxes and sometimes state and local income tax, meaning more money goes into your pocket.
- Low volatility. Municipal bonds — while not completely risk-free — are one of the safest investments for your money.
- Minimal default risk. Since muni bonds are mostly safe, your default risk is very low.
Cons
- Market prices could tank. If interest rates go up, the market prices of existing bonds will go down. That means you could earn less.
- Not inflation-friendly. Municipal bonds don’t hold up against inflation as well as stocks do. When inflation rises, a muni’s fixed payment is less attractive.
- Still a chance of default. While default risk is very low, municipal bonds could still go into default. For example, the city of Detroit filed for Chapter 9 bankruptcy in 2013 — the largest municipal bankruptcy in U.S. history. Jefferson County, Ala., another prominent example, filed in 2011.
While municipal bonds are generally sound investments for people looking to keep their taxes down and risks low, they might not be right for every type of investor.
What to consider when investing in municipal bonds
Individual bonds vs. funds
One of the first questions for muni investors is whether to buy individual bonds, mutual funds or exchange-traded funds (ETFs). The advantage of buying individual bonds is that you could earn a higher total return, assuming the issuer doesn’t default. By contrast, with mutual funds and ETFs, you have a diversified portfolio of bonds and so earn the weighted average return of those investments, which will be lower than the best-paying muni bonds.
Buying individual muni bonds can be expensive. That’s because the bond market tends to have wide bid-ask spreads, making it more expensive for investors in individual bonds to enter and exit a position. In contrast, when buying an ETF or mutual fund, the spread is narrow or even non-existent, meaning you’re getting full value for your money.
Expenses are often lower for ETFs, compared to mutual funds, but mutual funds carry some advantages over ETFs. While holdings in ETFs are usually based on a passively constructed index, managers at actively traded mutual funds can choose their holdings as they see fit, potentially generating higher returns than the index, though often lower.
In choosing a muni bond mutual fund, you want to start with ones that have a history of success. Look at how a fund has performed in down markets. Also look for funds with below-average expenses, as there are plenty of good ones available.
Bottom line
With a low default risk and generous tax exemptions, municipal bonds can be a good decision for an investor’s portfolio.
But be mindful that “low risk” doesn’t mean “risk-free.” While cities and local governments aren’t likely to default, there’s still a chance they might. Investments carry risk, regardless of what that investment is. Be careful as you put your money into any investment, including municipal bonds.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
FAQs
Muni bonds are usually exempt from federal taxes and sometimes state and local income tax, meaning more money goes into your pocket. Low volatility. Municipal bonds — while not completely risk-free — are one of the safest investments for your money. Minimal default risk.
What is a municipal bond and how does it work? ›
Municipal bonds (munis) are debt obligations issued by government entities. When you buy a municipal bond, you are loaning money to the issuer in exchange for a set number of interest payments over a predetermined period.
What are the risks of municipal bonds? ›
Important information on risk
Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities.
Are municipal bonds a good investment? ›
Investing in municipal bonds is a good way to preserve capital while generating interest. Municipal bonds hold several tax advantages over corporate bonds. Another advantage that munis have over corporate bonds is a much lower rate of default.
What is an example of a municipal bond? ›
A municipal bond is a debt obligation issued by a nonprofit organization, a private-sector corporation, or another public entity using the loan for public projects, such as constructing schools, hospitals, and highways.
At what income level do municipal bonds make sense? ›
If you sit in the 35% income tax bracket and live in a state with relatively high income tax rates, then investing in municipal bonds (munis, for short) will likely be a better option than taxable bonds. Alternatively, if your income is in the 12% tax bracket, then you may want to steer clear of municipal bonds.
How do I buy US municipal bonds? ›
Brokerage Firms: Many brokerage firms offer a wide selection of municipal bonds to individual investors. Online brokerages provide a listing of newly issued municipal bonds, or a person can purchase previously owned bonds from a section called the secondary market within the brokerage site.
Are municipal bonds safe in a recession? ›
Stability in periods of crisis
In fact, compared to other bond markets, the credit-quality ratings of the municipal sector have been very stable, not only during the COVID-19 crisis but also during the Great Recession of 2008 and other previous economic downturns.
Why am I losing money on municipal bonds? ›
Municipal bonds, like all bonds, pose interest rate risk. The longer the term of the bond, the greater the risk. If interest rates rise during the term of your bond, you're losing out on a better rate. This will also cause the bond you are holding to decline in value.
What is the current interest rate on municipal bonds? ›
AA RATED MUNI BONDS
| issue | maturity range | today |
|---|
| national | 10 year | 2.80 |
| national | 20 year | 3.80 |
| national | 30 year | 4.10 |
If you're looking for safety and predictability with your investments, CDs and bonds can offer both. However, CDs may ultimately be better for those who prefer the comfort of an insured investment. Bonds could be a better choice for those needing the tax advantages that municipal bonds offer.
What are the highest paying municipal bonds? ›
Here are the best High Yield Muni funds
- VanEck Short High Yield Muni ETF.
- VanEck High Yield Muni ETF.
- SPDR® Nuveen Blmbg Hi Yld Muncpl Bd ETF.
- VanEck CEF Municipal Income ETF.
- BlackRock High Yield Muni Income Bd ETF.
- First Trust Municipal High Income ETF.
- Franklin Dynamic Municipal Bond ETF.
Investment minimums for municipal bonds are typically $5,000 per bond, so an investor with limited funds to invest and who is seeking exposure to a wide range of maturities, sectors and credits might consider a mutual fund or an ETF.
Can municipal bonds lose value? ›
Significant events that transpired after an investor purchased a bond, such as ratings downgrades or other material events which may reflect an increased likelihood of default on the bond, may cause potential investors to value the bond at a lower value than the price paid by the investor.
Do municipal bonds pay interest monthly? ›
Unless an investor happens to trade a municipal bond on an interest payment date, some accrued interest must be settled in the transaction, which will affect the price of the bond. Generally fixed rate municipal bonds pay interest on a semiannual basis such as on June 30 and December 31 of each year.
Are muni bonds tax free? ›
A major benefit of municipal bonds, or "munis," is that the interest they pay is generally exempt from federal income taxes. They're also generally exempt from state income taxes if the issuer is from the investor's home state.
Can you lose money when you invest in a municipal bond? ›
Municipal bonds, like all bonds, pose interest rate risk. The longer the term of the bond, the greater the risk. If interest rates rise during the term of your bond, you're losing out on a better rate. This will also cause the bond you are holding to decline in value.
How are municipal bonds paid out? ›
Generally fixed rate municipal bonds pay interest on a semiannual basis such as on June 30 and December 31 of each year. However, municipal bonds can have different payment periods and dates, such as an annual payment.
What are the pros and cons of municipal bonds? ›
Pros and cons of municipal bonds
| Pros | Cons |
|---|
| Tax-exempt from federal tax and possibly state and local tax | The bond price could fall |
| Low volatility | Not inflation-friendly |
| Minimal default risk | Still a chance of default |
Jul 29, 2022
