Should You Invest In Municipal Bonds?

Investing in muni or municipal bonds gives you an excellent opportunity to earn tax-free income through the interest you receive from the issuer. State and local governments issue debt securities to raise funds for their daily obligations and public projects such as schools and highway construction. Moreover, muni bonds act like a loan where the holder is a creditor.

Like their treasury and corporate counterparts, muni bonds also have a significant share in the securities market. They’re relatively low-risk bonds due backing by state and local governments.

Curious to know more about the ‘Muni Bonds’? This article provides in-depth insight into this type of investment. Let’s dive in.

What Are Municipal Bonds?

Municipal bonds are income-generating debt securities that the local or state government issues to get funds for financing public projects and day-to-day obligations. Although muni bonds have taxable and tax-exempt income, the tax-exempt bonds are more popular as the income they generate is exempt from federal taxes and most cases, local and state income taxes. 

To determine whether municipal bond investing makes sense for you, it’s useful to compare the tax-exempt yield with that of a similar taxable corporate bond. An online tax-equivalent yield calculator, or TEY, can help you decide whether the taxable bond or muni bond delivers the best after tax return.

The government entities fund projects from municipal bond sales such as building hospitals, airports, highways, schools, and sewer systems. 

When you purchase muni bonds, you lend money to the issuer. In exchange, you get fixed interest payments (usually after every six months) and a return of the principal (original investment) upon the bond’s maturity date. 

The bond’s maturity duration is usually several years in the future: Short-term one is 1-3 years, while long-term bonds mature in a decade or more. 

In most cases, muni bonds provide high-credit quality. So, they’re an ideal option if you’re an income-oriented investor aiming to minimize federal income tax and maybe state income tax bills.

How Do Municipal Bonds Work?

Municipal bonds work by the government issuing bonds and paying regular semi-annual interest to the holders until the end of the agreed duration. Buying muni bonds is lending the issue money, and once the bonds mature (end of the loan term), you get back the full principal amount.  While you own the bond, you’ll receive regular tax-exempt interest payments.

How Much Do Municipal Bonds Pay?

Municipal bonds pay a fixed payment, sometimes called a coupon. You receive this interest payment from the issuer in the form of annual interest divided into two equal installments (semi-annually). If you buy a municipal bond fund, which is comprised of many bonds, you might receive more frequent payments. 

For example, if you buy municipal bonds worth $10,000 that are due 20 years and pay 4% interest, you loan the issuer $10,000 for 20 years. In exchange for the loan, the municipality pays you $400 annually, usually payable in two equal installments of $200 every 6 months. At maturity, in 20 years, you then get back your $10,000 investment. During those 20 years, you can sell your bond. Although until maturity, The price of your bond might be worth more or less than par value or $10,000.

Like all bonds, the principal value will rise and fall. Unless you own a bond until maturity, you might receive more or less than you originally paid for the bond. For example, assume that you bought a 10 year municipal bond at par for $1,000, with a coupon or interest rate of 3%. If interest rates increase, the value of that bond will decline. That won’t matter if you own the bond until maturity. But, if you sell it after market rates rise, you’ll most certainly receive less than you originally paid for the muni bond. That’s because, the old bond is competing with higher yielding newly issued bonds. A purchaser of the 3% bond will not be willing to pay full price or par value for the bond because they can buy a newly issued bond with a higher coupon in the open market.

Occasionally, if you’re subject to the alternative minimum tax (AMT), you might have to pay tax on tax-exempt munis. In this case it’s wise to consult  a tax expert before investing in muni bonds. 

Municipal Bonds Pros and Cons

Pros

• Provides tax exempt income
• Easy to buy in a mutual fund or ETF
• Many types of municipal bonds available

Cons

• Not for all, those in lower tax brackets might not benefit
• Need to make sure that you are getting a municipal bond or fund that offers a better tax equivalent yield than a corporate or government bond
• Individual municipal bonds can be confusing to purchase without guidance from a financial advisor

What Are the Various Types of Municipal Bonds?

There are two popular types of municipal bonds, including the following:

• General obligation bonds (GOs)
• Revenue bonds 

General Obligation Bonds

GOs are muni bonds a local or state government issues to raise funds for public projects that generate revenue streams indirectly. The issuing government uses its general revenue to support this bond type: It collects tax from residents to pay bondholders.

The two types of GO bonds are:

• Limited-tax GO bond: A municipality raises property taxes within a specified limit to meet the debt obligations. Taxpayer approval isn’t a requirement in this case.
• Unlimited-tax GO bond: The issuer pledges to levy taxes at an unrestricted rate until full repayment of the bond. Thus, the property tax rate can increase up to 100%. Unlike the limited tax case, rate increments must have the taxpayers’ consent. 

Revenue Bonds

Revenue bonds are municipal bonds the issuing government uses to raise funds for projects that generate income streams directly. Specific revenue sources like sewer systems and toll roads support this type of muni bond. In the case of revenue bonds, an entity’s operating revenues guarantee the bond obligation’s repayment. 

Municipal Bonds Vs. Corporate Bonds

The main differences between municipal bonds and corporate bonds are the issuer and tax treatment of the income. While a local or state government issues municipal bonds, corporate bonds are issued by a company. The two types of bonds have other differences, as indicated below.

A local or state government raises funds by issuing muni bonds to finance public projects like infrastructure. On the other hand, a company will issue corporate bonds to raise capital to build a new plant, grow an existing business, or purchase equipment.

While municipal bonds have taxable and tax-exempt income options, corporate bonds only have the taxable version. However, corporate bonds offer yields higher returns than their muni counterparts.

Your tax bracket and the yields of each bond type will determine whether corporate or municipal bonds are best for you,  Here’s where a tax-equivalent yield calculator will come in handy, to help you decide.  To best compare the after-tax benefit of munis vs corporate bonds, check out an online tax equivalent yield calculator. This Bankrate tax equivalent yield calculator is easy to use.

Municipal Bonds Vs. Government Bonds

The main difference between municipality bonds and government (treasury) bonds is interest taxation. Although some municipal bonds pay taxable income, the most common ones are tax-exempt. On the contrary, government bonds income is taxable at the federal level. Most government bonds are tax-exempt at the state and local levels. Government bonds might make sense if you live in a high tax state.

The other difference is that while municipalities and state government entities issue munis, treasury bonds are issued by the federal government.

Although muni bonds tend to be safer and have higher yields than many corporate bonds, they’re less safe and may have lower yields than government bonds. Why? The US government has the least default risk of any bond issuer. It’s unlikely that the government will fail or run out of money. While corporations and even municipalities can occasionally go bankrupt and fail to pay their bills. This could lead to a default where bond investors don’t receive the amount they are due. 

Tax-free Municipal Bond Funds

A tax-free municipal bond is one whose holder isn’t required to pay tax on the interest they earn. The bonds are usually federally tax-free and may also be free from local and state taxes. Thus, depending on where you live, you may never pay income tax from your muni bond yields. Even so, you might be subject to AMT.

Usually, the tax-free munis are rated investment grade: They have a relatively low default risk (low credit risk) in comparison with corporate bonds. Thus, they’re ideal for reducing drawdowns and volatility in your investment portfolio. Unfortunately, investment-grade bond yields are lower than non-investment-grade ones. That’s because investors inriskier investments demand higher yields in exchange for the additional risk.

What Are the Tax-free Municipal Bond Rates?

The tax-free municipal bond rates will vary based upon market interest rates, term and credit rating of the bond issuer. Longer term bonds usually pay higher interest than shorter term bonds, although not always.   While safer, bonds with higher credit quality have lower interest rates, than riskier, lower rated bond.

Advantages and Disadvantages of Municipal Bonds

Below are the advantages and disadvantages of municipal bonds:

Advantages of Municipal Bonds:

• Tax-exempt: The most attractive benefit of municipal bonds is their ability to generate tax-free income. They’re usually exempt from federal taxes and may also be free from local and state income tax. Consequently, you might end up with more after tax dollars.
• Diversification: Munis are a good way of diversifying your holding to minimize your risk across your investment portfolio. In general, they’re slightly riskier than treasuries but yield more, and less riskier than corporate bonds but yield less than them.
• A steady income stream: Since munis have fixed interest rates, you receive regular payments, usually twice a year after every 6 months. Or more frequently if you invest in a municipal bond ETF or mutual fund.  
• Less risk: Although munis aren’t 100% risk-free, they’re a safer investment option than other asset classes due to their low volatility. 
• Minimal default rates: Municipal bonds have a low default risk; thus, your money is quite  secure, when in vesting in a municipal bond portfolio. We recommend buying a fund or several muni bonds, to minimize default risk from one security.

Disadvantages of Municipal Bonds:

• Default risk: Although munis have very low default risk, there’s still the possibility of default. For example, the largest state  bankruptcy in U.S. history is the recent Puerto Rico bankruptcy and debt restructuring. Puerto Rico’s municipal bonds presently carry a low D rating with Fitch and Standard and Poors rating services. . 
• Inflation unfriendliness: Municipality bonds, and fixed rate bonds in general will suffer as inflation rises, as the purchasing power of your income and principal payments will decrease. 
• Lower yields: The interest rate of muni bonds can be lower than those of corporate bonds. 
• Market price decline: When market interest rates increase, existing muni bond prices decrease. That’s because investors can achieve higher returns on new bonds, and will pay less for existing bonds, with lower interest or coupon rates.  
• Liquidity issues: You may be unable to cash out your muni bonds due to the lack of an active market when you want to sell them. 
• Opportunity cost: If you’re in a lower tax bracket, the tax advantages won’t be as valuable to you as they are to your higher tax bracket counterpart. 

Should You Invest In Municipal Bonds Now?

Yes, you should invest in muni bonds. Investing in muni bonds is an excellent way of preserving capital as you receive interest payments from the issuer. Moreover, most of these bonds are federal tax-exempt and sometimes local and state tax-free.

What’s more, highly-rated muni bonds are a safer investment than nearly any other investment because their default rate is very low. If held to maturity, you will get the full principal value of your bond back, baring any default. However, if interest rates rise, and you sell before maturity, you may get stuck selling a bond for less than full value.

Should you invest in a 100% municipal bond portfolio?

Muni bonds are a good investment for the fixed income portion of a diversified investment portfolio. But, are there any cirecumstances when one should have all of their investments in municipal bonds. Well, if you don’t have any retirement accounts and you’re not seeking any capital appreciation, then a 100% muni bond portfolio might be okay. But, the interest rate risk make muni bonds risky.

For the most conservative investors, we still recommend an allocation to the stock market. That allows a bit of growth in your capital and can offset the losses from a muni bond portfolio, should interest rates rise.

How Do You Invest in Municipal Bonds?

There are three major ways to invest in municipal bonds. According to Municipal Securities Rulemaking Board (MSRB), you have various ways to participate in the municipal bond market.  Also, you can use online brokers or bank departments that deal with municipal securities; many robo-advisors have them in their portfolio mix as well.

Here’s how to invest:

• Municipal bond funds: You can invest in munis through municipal bond mutual funds or exchange-traded funds (ETFs) if you aren’t comfortable purchasing municipal bonds on your own. The investment method gives you access to a well-diversified muni bond portfolio: Varied risk and return, various bond types and projects, and different credit ratings. Also, the default risk lessens.
• Individual municipal bonds: You can use a buy-to-hold strategy to purchase bonds and hold them until maturity. The investment technique allows you to research and select ideal bonds for your portfolio: Tax benefits, maturity date, risk, and return. To own individual municipal bonds, it’s important to buy five or more bonds, to increae diversification and lower default risk.
• Municipal bonds ladders: If you hold until maturity, you’ll get back your principal at the end of the 1-30 year term. Therefore, you may consider buying multiple bonds with incremental maturity dates (ladders). The maturity sequence will provide a ready stream of maturing bonds for regular cash flow.

Should I Buy Municipal Bond Funds Now – Wrap up?

Yes, you should buy municipal bonds funds now if you’re in a higher tax bracket. However, investors have had it rough recently, and you may wonder, will municipal bonds recover? Thankfully, the muni bonds market news today promises investors attractive yields with reasonable risks. Muni bonds are a good addition to the fixed portion of your investment portfolio, in a taxable account. 

Don’t buy tax-exempt muni bonds in a retirement IRA or 401k account. Those retirement accounts are already protected from tax payments.

The other factor that would lead your move to buy muni bonds is the benefit attached to these debt securities over their alternatives. The most popular one is the tax-exempt income the issuer pays you at a fixed annual interest rate.

Others include the ability to diversify your investment portfolio, provide a steady income stream, minimize the default risk, and has low volatility, making it a safer investment option than risker high-yield bonds and stock market shares or funds.

Even so, municipal bonds have a few drawbacks to consider. Munis have lower yields and total return potential than their alternatives, such as individual stocks and stock ETFs and mutual funds. Munis are less able to cope with inflation. Also, their market price declines with an increase in the interest rate, and in some cases, the default risk may be a reality.

For wealthier investors, in a higher tax bracket, municipal bonds are a sound addition to a diversified portfolio. Although we don’t recommend investing in a 100% municipal bond portfolio, unless your only goal is capital preservation, and not growth. 

Fortunately, this article is an excellent guide if you decide to include muni bonds in your portfolio.

FAQ

What percent of my portfolio should be in municipal bonds?

This depends upon your risk tolerance, age and asset allocation goals. A balanced portfolio might invest 25% or more in municipal bonds. If you can benefit from tax-exempt income, the fixed-income portion of your portfolio could have a significant share of muni bonds.

Just remember to keep municipal bonds in your taxable, not your retirement account.

Are municipal bonds a good investment in 2023?

Yes, munis are a good buy now. Municipal bonds are a higher-quality asset class offering high yields now. Approximately 85% of the munis market ranks A or higher, and the bonds’ performance is currently healthy and current interest rates are higher than they’ve been in many years.  

How often do municipal bonds fail?

On average, investment-grade municipal bonds have cumulative default rates summing up to 0.09% over 10 years. Comparatively, the global corporate market has a rate of 2.17%. Hence, the muni default rate ismore than twenty times lower than corporate default rates (Moody’s data dated 31st December 2021).

What is the main downside of municipal bonds?

The main downside of municipal bonds is interest rate risk. Although muni bonds are safe due to the low default risk, they carry the risk of rising rates. Hence, an increase in interest rates causes a decrease in bond prices. The risk is more real for muni funds and ETF investors than individual bond holders, who can own the bonds until maturity and receive the par value. Although interest rate risk applies to all bonds and bond funds. 

Is it a good time to invest in a municipal bond fund?

Yes, it’s a good time to invest in a municipal bond fund. With ultra low interest rates through 2022, muni bonds haven’t been particularly attractive. With higher yields in 2023,  investors can finally earn attractive returns without undue risk. It’s best to consider a bond fund as a long term holding and diversify across short and long term bonds, And, when interest rates recede, your bond fund value should increase.

What is the outlook for municipal bonds?

The muni bond outlook 2023 is good. Fed is moving towards the end of the interest rate hiking cycle at the end of 2023. Interest rates should stabilize which will lower the bond price volatility.

Are municipal bonds worth buying?

Yes, municipal bonds are worth buying. Munis have remarkable benefits, and having them as part of your investment portfolio is a wise decision if you are in a high tax bracket. The most attractive benefit for these debt securities is their tax-exempt status. Other benefits include a steady income stream, minimal default risk and portfolio diversification.

This post originally appeared at Barbara Friedberg Personal Finance.

Category: Bonds