Stocks continue to be the best means of building wealth over time, but that doesn’t mean bonds should be left out of your portfolio. The advantage of bonds is that their values tend to fluctuate less frequently and drastically than stock values while still offering interest income.
Treasury bonds and corporate bonds tend to get the lion’s share of attention, but municipalities such as states, cities, and counties issue bonds, too. There’s a large market for investing in municipal bonds, or “muni” bonds. And just as with their corporate and federal government counterparts, there are plenty of good reasons to add municipal bonds to your portfolio.
This article contains all you need to know about investing in municipal bonds.
How Municipal Bonds Work
A municipal bond is a debt issued by a state or municipality to fund public works. Like other bonds, investors lend money to the issuer for a predetermined period of time. The issuer promises to pay the investor interest over the term of the bond (usually twice a year) and then return the principal to the investor when the bond matures.
For example, if you invest $5,000 in a 10-year municipal bond paying 5% interest, you’ve loaned $5,000 for 10 years. In return, the municipality will pay you $250 annually in interest — typically in biannual installments — and then return your $5,000 at maturity in 10 years.
Bond values are usually more stable than stocks since the value is easy to calculate: You add up the bond’s face value and the interest it will pay. The main thing that affects the value of a bond is the interest rate. A bond that pays a higher interest rate than a new issue — meaning brand-new bonds just coming up for sale — is worth more money, while a bond that pays a lower interest rate than a new issue is worth less money. That’s because the price of selling or buying the bond is adjusted up or down based on current available yields.
But so long as you hold the bond to maturity and the issuer continues honoring its obligation to pay you, you’ll get all your money back, plus interest.
Types of Municipal Bonds
Municipal bonds come in two varieties: General obligation and revenue bonds. General obligation bonds are used to finance public projects that aren’t linked to a particular revenue stream. Revenue bonds, by contrast, are used to finance public projects with the potential to generate revenue. There are advantages and drawbacks to investing in each type.
General obligation bonds
General obligation bonds are used to fund public projects, such as building a park or improving a school system — things that don’t inherently make money but improve the communities they serve. General obligation bonds are backed by the full faith and credit of the issuer, meaning they’re not secured by any specific asset that bondholders could repossess. As such, general obligation bonds have traditionally been one of the safest kinds of bonds you can buy.
Revenue bonds
Revenue bonds are issued by municipalities to finance revenue-generating projects like a toll road or concert hall. The cash generated by the project will pay back investors in those bonds. Revenue bonds have higher default rates than general obligation bonds since the funds are used for a specific project that may or may not be completed on time and within budget and may not generate the projected revenues. So it’s important to research the issuer’s credit rating before risking your capital.
On the whole, municipal bonds have a low default rate. Between 1970 and 2015, just 99 muni bond defaults were issued. Of these, only nine general obligation bonds defaulted, and not a single municipal bond with the highest credit rating defaulted. Municipal bonds have been 50 to 100 times less likely to default than corporate bonds.
However, municipal bonds are not risk-free. In recent years, some governments have defaulted on their municipal bonds, including Detroit in 2013 and Puerto Rico in 2016.
Municipal bonds generally offer lower interest rates than corporate bonds, although, as with Treasury bonds, the interest is tax-free. (Keep in mind, however, that the tax benefits of municipal bonds only apply to interest payments — not capital gains. If you sell a bond for more than you paid, those gains are still taxable.)
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Muni bonds carry interest rate risk as well. If interest rates go up while you still own a particular muni bond, you will earn a lower yield than you’d be able to get from a new issue in the future. Interest rate changes will affect the value of your bonds on the secondary market, too. If you have to sell a bond in the future, you may have to sell it below redemption value to compensate for the lower yield if rates go up. But as long as you hold the bond to maturity, you’ll earn its face value back from the issuer.
How are Municipal Bonds Rated?
Regardless of whether you invest in a general obligation bond or a revenue bond, they are all given a rating. The rating system is managed by three major credit firms, which are Standard & Poor’s (S&P), Moody’s, and Fitch. The rating takes into account aspects of the issuer such as: creditworthiness, debt burden, economic conditions, historical payment history, and the regulatory and political environment.
At the top of the rating structure is AAA, Aa, or A depending on the credit firm, where the issuer is considered to have the lowest risk of default, and tends to offer a lower interest rate. At the bottom end of the ratings is the CCC, which is often referred to as ”High Yield” or “Junk Bonds” that have a higher level of risk, and also offer a higher interest rate.
There are three major ratings agencies that grade bond issuers based on their likelihood of meeting their financial obligations versus defaulting on them. They are S&P Global (SPGI -0.09%), Moody’s (MCO -0.45%), and Fitch.
Generally, the higher an issuer’s credit rating, the lower the interest rate its bonds pay. Conversely, issuers with a lower rating generally must offer higher interest rates to offset the associated risk. But remember that bond ratings can change. Just because an issuer starts out with a strong rating doesn’t mean it can’t get downgraded if its financial circumstances change, such as Detroit a decade ago.
There’s good news even in most bad situations, however. Muni bonds have a high rate of recovery even when they default, but your capital can be tied up longer than the term of the bond, and investors rarely recoup interest not paid. So be sure to consider all the implications when picking which municipal bonds to buy.
How are municipal bonds taxed?
Easily, one of the most appealing aspects of investing in municipal bonds is their tax advantage. The interest income earned from most municipal bonds is typically exempt from federal income taxes. Additionally, if you invest in municipal bonds issued within your state of residence, the interest income is often exempt from state and local taxes as well.
Each investor should research their local bond requirements to verify the tax advantages. This tax-exempt status can lead to higher after-tax returns compared to taxable investments such as CDs and Treasuries, making municipal bonds particularly appealing to investors in higher tax brackets. However, it is essential to note that certain types of municipal bonds, such as private activity bonds, may be subject to the alternative minimum tax (AMT).
What are the Ways to Buy Municipal Bonds?
Brokerages remain one of the most direct ways to purchase municipal bonds. These companies provide self-directed investment accounts that allow you to monitor bond prices, ratings, and more. For example, TD Ameritrade has the Bond Wizard™ that allows you to select from thousands of bonds, including munis.
TD charges just a $1 per bond transaction fee for this, though some municipal bond purchases may come with further charges. It may cost more to invest in these bonds with Merrill Edge, but its research tools are comparable.
Many times, investors will purchase municipal bonds on an individual basis. However, you can buy them as part of exchange-traded funds (ETF) and mutual funds as well. These are perfect if you don’t have much to spend on your investments. Muni ETFs and mutual funds will diversify your money across an array of municipal bonds without the costs that are customarily associated with doing so individually.
Perhaps you don’t feel ready to decide on municipal bond investments on your own. If you feel this way, you may want to consult a financial advisor. Municipal bonds are favorites of many advisory firms, especially for clients who are more risk-averse. In most cases, your advisor will work with you to develop your personal risk tolerance, time horizon and other factors to discern whether or not municipal bonds are worth including in your portfolio.
Robo-advisors are a viable alternative to financial advisors. Generally speaking, robo-advisors come with cheaper management fees than their human counterparts. These automated services attach your personal preferences to a predetermined risk profile. Risk profiles consist of asset allocations that are made up of varying percentages of equities, municipal bonds and any number of other investments that align with your risk tolerance.
Government entities, most notably state, county and city governments, submit municipal bonds to the public as debt securities. This money helps to fund public works projects, like roads and freeways, and build schools and other parts of society’s infrastructure. In essence, municipal bonds are you (the investor) lending money to these governments with the expectation of regular interest payments. These don’t go on forever, though, as all munis have maturation dates years in the future.
Tax benefits are a major draw of municipal bonds. For example, the interest income you receive over the maturation of a muni is exempt from federal taxes. In some cases, you may even find that you can skip out on state and local taxes as well. This, however, is ordinarily reserved for residents who invest in their own state or local government’s munis.
1. General Obligation Bonds
As the standard municipal bond, general obligation bonds (GO bonds) are officially backed by the taxing power and credit of the issuing government entity. In layman’s terms, this refers to the method through which investors will be paid back for their investment, which for GO bonds is either through revenue generated from completed projects or taxation. This makes these investments incredibly safe, as they do not call for collateral and the issuing governments promise the appropriate returns.
2. Revenue Bonds
Revenue bonds pay back investors solely through the money they earn from a finished project. The best way to envision this is the building of a toll plaza on a highway. If a government uses the assets invested in its revenue bonds to fund the tolls, the money that drivers pay will go to repaying investors. They are mostly sold in $5,000 increments, and because they lack taxation as a repayment method, they are riskier than GO bonds. In return, they are paired with stronger interest rates. Revenue bonds are usually long-term investments, as their maturation dates are often a couple of decades in the future.
3. Municipal Notes
Contrary to GO and revenue bonds, municipal notes mature in anywhere from a few months to three years. Governments also offer these also under the purpose of funding public projects that require more capital. They come in three forms: tax anticipation notes (TANs), revenue anticipation notes (RANs) and bond anticipation notes (BANs). Each of these choices are secured by taxes, non-tax revenue and future long-term bonds, respectively.
Some Benefits and Risks of Municipal Bonds
Like most other bonds, municipal bonds are, for the most part, very reliable investments. Because they offer the backing of county, state and federal governments, munis generally deliver reliable, semi-annual returns. Through this, these investments are perfect for balancing your portfolio for the long term, being that it takes decades for them to mature.
Municipal bonds are not immune to risk despite their safe nature. In fact, there are three main types of risk to be looking out for:
- Interest Rate Risk: As long as interest rates stay low, the market value of a municipal bond will remain high. However, if interest rates begin to increase, your muni investment could lose overall market value.
- Call Risk: Some municipal bonds are callable, which means that government issuers will have the opportunity to pay them off early if interest rates go down. Should this happen, you could lose out on returns.
- Credit Risk: All bonds have credit ratings that help to illustrate to possible investors how reliable the municipal bond appears to be. But even government entities can default, in which case your returns may end up in serious jeopardy.
Equities are some of the riskiest investments, as they often fluctuate in value with the performance of a company. This quality, however, affords them much higher return possibilities than their peers, including municipal bonds. Which one is better suited for your portfolio is dependent on what your personal risk tolerance is, as well as what your ultimate financial goals are. If you have a while before retirement, it might be worth taking a risk with more equities. But if your golden years are on the horizon, municipal bonds offer reliable returns.
ETFs are one of the most popular investment choices. Diversification is key to the health of any portfolio, so the fact that ETFs are inherently diversified makes them a favorite. ETFs come in many versions, such as market-index ETFs, equity ETFs, alternative investment ETFs and even municipal bond ETFs. These funds provide a perfect balance for investors who want the benefits of munis but are unable to diversify due to a lack of trading confidence or funds.
Bottom Line
Municipal bonds are a worthwhile investment for anyone, regardless of risk preference. For risk-averse investors, fixed-income securities like munis are essential. On the other hand, even the most daring investor needs munis and other fixed income to balance out stocks. Although municipal bonds can be pricey to invest in individually, muni ETFs are a viable alternative.
