Municipal bonds are debt securities issued by local governments and public agencies to fund essential projects such as infrastructure improvements, school construction, and public utilities. When investors purchase these bonds, they are effectively lending money to the issuing government in exchange for regular interest payments and the return of the principal amount at maturity. While municipal bonds are generally considered safer than corporate bonds, they carry slightly more risk than U.S. Treasury bonds. However, their tax advantages and relatively low default rates make them an appealing option for investors seeking stable, tax-efficient income.
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What Is a Municipal Bond?
A municipal bond is a debt security issued by state and local governments, as well as their agencies, to finance public projects such as roads, schools, hospitals, and water infrastructure. When investors buy municipal bonds, they are essentially lending money to the government in exchange for periodic interest payments and the return of the principal amount at maturity. These bonds are considered relatively low-risk investments, as they are backed by government entities and, in some cases, specific revenue streams.
There are two main types of municipal bonds: General Obligation (GO) bonds and Revenue bonds. GO bonds are backed by the issuing municipality’s credit and tax revenue, making them one of the safest types of bonds. Revenue bonds, on the other hand, are repaid through income generated by a specific project, such as toll roads, bridges, or public utilities. While revenue bonds may carry slightly higher risk than GO bonds, they still provide a stable income stream to investors.
A major benefit of municipal bonds is that the interest income earned is often exempt from federal income tax and, in many cases, from state and local taxes as well. This makes them particularly attractive to high-income investors looking to reduce their tax burden while earning a steady income. Additionally, municipal bonds tend to have lower default rates compared to corporate bonds, further reinforcing their reputation as a safe investment choice.
Municipal Bond Prices and Interest Rates
Municipal bonds offer a fixed rate of return in the form of interest, usually paid out every six months. If you buy an individual bond, this interest doesn’t compound. You simply receive the money in regular, tax-free intervals semiannually.
The general interest rate, the one you hear about on the news when the Federal Reserve (the “Fed”) makes announcements, has an inverse relationship with bond prices. When the interest rate goes up, bond prices go down. When the interest rate goes down, bond prices rise. While you hold your bond, its price fluctuates with interest rates. So, if you sell a bond before maturity, expect to get what the bond is worth at the time you sell it, even if that’s less (or more) than what you paid.
Tax-Free Municipal Bonds
Tax-free municipal bonds are debt securities issued by state and local governments or their agencies to fund public projects such as roads, schools, and water systems. The key advantage of these bonds is that the interest income earned by investors is generally exempt from federal income tax and, in many cases, state and local taxes if the investor resides in the state where the bond is issued.
Tax-free municipal bonds offer several advantages, making them an attractive investment for income-focused investors, particularly those in higher tax brackets. One of the primary benefits is that the interest income earned from these bonds is exempt from federal income tax and, in many cases, state and local taxes if the investor resides in the state where the bond is issued. This tax advantage effectively increases the investor’s after-tax return compared to taxable bonds with similar yields.
How to Buy Municipal Bonds
If you want to buy municipal bonds, you can either buy each individual bond through a broker or invest in many bonds at once, through a bond fund, mutual fund or Exchange Traded Fund (ETF). If you want to buy individual bonds, you’ll need plenty of money to invest, and you’ll be responsible for choosing low-risk bonds and diversifying your holdings. On the other hand, if you buy a bond fund, you’ll have built-in diversification without taking the time to investigate each bond.
As far as fees go, some analysts say that there isn’t much of a difference between buying individual bonds and buying a fund. Funds come with an explicitly stated expense ratio (0.2%, say). Individual bonds do not, but the brokerage’s commission fees are generally included in the price you pay. With a bond fund, you can reinvest the interest payments you receive each month. With individual bonds, you’ll have to wait until the cash you accumulate in interest payments equals the amount you need to buy another bond.
If you go the route of choosing a bond fund, you can choose your fund based on several factors. You can buy single-state funds or national funds that hold bonds from many states. You can buy funds that have long terms or funds with short terms, depending on when the bonds mature. If you’re chasing yields, you can buy funds with non-investment grade bonds that offer higher interest payments to compensate for their higher risk of default.
Municipal Bonds vs. Treasury Bonds
Let’s compare municipal bonds with Treasury bonds. Treasury bonds are considered to be safe and dependable places to stash investment money. When stocks fall, as in a recession, investors generally flock to Treasury bonds. People in or near retirement also tend to favor Treasury bonds. The bonds are backed by the “full faith and credit” of the US government, and the risk of a default is negligible.
Cities, on the other hand, can default and go bankrupt. “Investment-grade” bonds are bonds that have a very low risk of default, but there are plenty of other, non-investment-grade bonds.
Interest from Treasury bonds is exempt from state and local taxes, but is subject to federal income taxes. Interest from municipal bonds, as we’ve covered, is exempt from federal taxes, but not necessarily exempt from state and local taxes. Remember how we said that municipal bonds are riskier investments? Well, as a result, the interest rates on municipal bonds are generally higher than on Treasury bonds.
Bottom Line
Municipal bonds are often attractive to investors who are eager to cut their federal tax bill. In many cases, if you live in the state that is issuing the bond you buy, the interest will be exempt from state income taxes, too. However, if paying low taxes is your main financial priority, you’d probably be well served by talking to a tax professional before you take the plunge and spend thousands on municipal bonds.
Tips for Investing
- It can be important for many to consult a financial advisor before making any major investment decisions. A financial advisor can analyze your full financial situation and determine which investments will be best. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goalss, get started now.
- Consider using an investment calculator to help you see how your portfolio choices might grow over time.
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