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
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.
What are municipal bonds ____________________? ›
Municipal bonds are debt securities issued by these organizations to bondholders. In other words, the bondholders are lending the City funds that are expected to be paid back at face value at a certain date, plus periodic interest payments.
What are municipal bonds explained? ›
Municipal bonds (or “munis” for short) are debt securities issued by states, cities, counties and other governmental entities to fund day-to-day obligations and to finance capital projects such as building schools, highways or sewer systems.
What are municipal bonds Quizlet? ›
A municipal bond is. a bond issued by a state or local government or municipality to finance such improvements as highways, state buildings, libraries, parks, and schools. Crowding out occurs when investment declines because. a budget deficit makes interest rates rise.
Are municipal bonds a good investment right now? ›
Although down for the year, munis are outperforming Treasuries, corporates, and the Agg. Source: Bloomberg Indices, as of 3/15/2024. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. Total returns from 12/31/2023 through 03/15/2024.
What is an example of a municipal bond? ›
Municipal bonds are bonds that are issued by municipal governments typically to fund municipal projects, such as: Construction of schools. Construction of libraries. Construction of infrastructure (roads, bridges, public transit)
What does municipal mean? ›
Municipal means associated with or belonging to a city or town that has its own local government.
What are the risks of 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.
Who benefits from municipal bonds? ›
Municipal Bonds
The proceeds of the bonds are used to finance projects that benefit the community such as roads, schools, bridges, sewers, parks or water treatment.
What is a bond for dummies? ›
The people who purchase a bond receive interest payments during the bond's term (or for as long as they hold the bond) at the bond's stated interest rate. When the bond matures (the term of the bond expires), the company pays back the bondholder the bond's face value.
Who buys municipal bonds? About 72 percent of bonds are owned by individuals directly or through mutual funds and the like. About 25 percent of bonds are owned by businesses, primarily property and casualty and life insurance companies, but also banks.
What is a municipal bond which is secured by? ›
Bonds are secured and payable by a tax levied annually on the property within the district. The amount of the tax levied on property owners to help pay for the debt service must be reasonable, but may change based on higher or lower project costs, tax collections and other variables. Special assessment districts.
Is a municipal bond short term? ›
Short Term Municipal Bond Subscriptions
A portfolio of primarily investment-grade, short-term municipal bonds with a targeted average weighted maturity of 3 years or less that seeks to provide current income exempt from regular federal income taxes to the extent consistent with preservation of capital.
What are municipal bonds pros and cons? ›
Although municipal bonds may have lower interest rates than riskier investments like corporate bonds or stocks, they offer stability for your capital with low default rates. Interest from munis is also generally exempt from federal taxes, making it an attractive investment.
How often do municipal bonds pay 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.
Why do people buy municipal bonds? ›
Investing in municipal bonds is a good way to preserve capital while generating interest. Most of them are exempt from federal taxes, and some are tax-free at the state and local levels as well. 1 Municipal bonds, also called "munis," help build infrastructure in your area.
Are municipal bonds fixed or floating? ›
Some muni bonds have fixed coupons, while others are variable. Muni bonds with floating coupon rates are called variable-rate demand bonds. The interest rates on these bonds generally are reset daily, weekly, or monthly. The bonds are issued for long-term financing with maturities ranging from 20 to 30 years.
Are muni bonds tax free? ›
Income from bonds issued by state, city, and local governments (municipal bonds, or munis) is generally free from federal taxes. * You will, however, have to report this income when filing your taxes. Municipal bond income is also usually free from state tax in the state where the bond was issued.
Is a municipal bond a Treasury? ›
The principal difference between municipal bonds and Treasury bonds, aside from the credit considerations, is that municipal bonds are tax-exempt, that is interest is exempt from federal income taxation.
Are municipal bonds an asset class? ›
Municipal bonds are typically known for offering tax-exempt income, making them a popular choice in taxable investment accounts for retirees, while historically being excluded from the possible mix for qualified retirement plans and IRAs.
