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What Are Tax-Free Municipal Bonds and Should You Invest?

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Tax-free municipal bonds are not just a source of investment but also a significant contributor to public projects such as roads, schools and hospitals. These debt instruments are issued by local or state governments, attracting investors for their provide tax-advantaged income. The interest earned from these bonds is typically exempt from federal taxes and, potentially, state and local taxes. However, while they offer certain benefits, they come with their own unique set of risks and are not suitable for all investors. Consider speaking with a financial advisor about whether tax-free municipal bonds are right for your portfolio.

Understanding Tax-Free Municipal Bonds

Imagine loaning money to your local government to help them build schools or hospitals and update infrastructure while receiving regular interest payments for your help. 

This is essentially how tax-free municipal bonds work. Investors lend money to the government in exchange for periodic interest payments until the bond reaches its maturity date, at which point the original investment is returned in full. It’s a go-to method for many municipalities to finance public projects, directly contributing to the socio-economic development of the area.

Municipal bonds – or “munis” – are generally considered a lower-risk investment compared to stocks and corporate bonds. Governments have a strong incentive to repay their debt, and historically, the default rates on municipal bonds have been relatively low.

Additionally, there’s a wide range of muni bonds to choose from, including general obligation bonds and revenue bonds. This diversity allows investors to tailor their portfolios to match their financial goals and risk tolerance.

Why Investors Buy Bonds

An investor researches municipal bonds to add to his portfolio.

The decision to invest in bonds is generally motivated by their attractive features including a comparably lower risk, predictable incomes through interest payments, and the potential diversification they afford an investment portfolio.

During economic downturns or periods of market volatility, investors flock to bonds for their perceived safety. Government bonds, in particular, are often considered a safe haven asset, offering security during turbulent times.

Bonds are renowned for providing a predictable and steady income stream. When you purchase a bond, you essentially lend money to the issuer in exchange for periodic interest payments and the return of the bond’s face value at maturity. This dependable income can be appealing, especially for retirees or those seeking stable returns.

These fixed-income assets also play a crucial role in diversifying an investment portfolio. They often behave differently from stocks, which means that holding both can help spread risk. This diversification can enhance overall portfolio stability.

Average Rate of Returns on Municipal Bonds

Return rates on municipal bonds fluctuate and depend upon varying factors like the creditworthiness of the issuer and the bond’s maturity date. For instance, as of September 2023, a 10-year AAA-rated municipal bond yielded 2.89%, according to Raymond James. While these numbers may seem less gratifying than, say, stocks or corporate bonds, they offer a different set of benefits.

Municipal bonds generally carry less risk than stocks and are tax-exempt, which for higher tax-bracket investors effectively increases the return rate. It’s crucial to highlight though, that they may not be the best choice for everyone and should be considered in light of personal financial circumstances.

Benefits of Municipal Bonds

The appeal of municipal bonds lies in their tax advantages. Their interest income is typically exempt from federal income tax, and potentially state and local taxes if the investor resides in the state where the bond was issued. For example, a $50,000 investment in municipal bonds yielding 2.89% could save an investor in the 35% tax bracket over $500 in federal taxes annually.

Along with these tax benefits, municipal bonds also provide steady, predictable income, making them a viable choice for income-focused investors. Moreover, they help to uplift local communities through infrastructure development and job creation, fostering a sense of societal contribution.

Risks of Investing in Municipal Bonds

Interest rate increases pose a threat to municipal bond investors with long-duration bonds.

Just as with every coin that has two sides, municipal bonds also come with a variety of risks despite their steady returns and tax advantages.

There is potential for loss with municipal bonds if the issuer defaults, interest rates rise dramatically, inflation spikes or if the bond is called early.

Here’s a look at the primary risks associated with municipal bonds:

Interest Rate Risk

Interest rate risk is one of the key threats to municipal bond investors.. When interest rates rise, the market value of existing bonds tends to decrease. Municipal bonds are no exception. If you invest in a long-term municipal bond with a fixed interest rate, you may miss out on higher yields offered by new bonds in a rising rate environment. And if you sell your bond on the secondary market before it matures, you may take a loss. 

Default Risk

Default risk is the chance that the issuer of the municipal bond will fail to make interest or principal payments. While municipal bonds are generally considered safe, they are not entirely immune to default. It’s essential to research the financial stability of the municipality issuing the bond before investing.

Purchasing-Power Risk

Municipal bonds may not always keep pace with inflation, leading to purchasing-power risk. The fixed-interest payments may not buy as much in the future due to rising prices. Investors should assess whether the potential tax benefits outweigh the risk of losing purchasing power.

Call Risk

Some municipal bonds are callable, meaning the issuer can repay the bond before its maturity date. This can be problematic for investors if the bond is called when interest rates are lower, as they may struggle to find comparable investment opportunities with similar yields.

Bottom Line

It’s important to underline that while municipal bonds offer advantages like tax benefits and steady returns, they also come with their own set of risks. These should all be considered before pursuing municipal bond investing. 

Investing Tips

  • Picking the right mix of investments for a portfolio is key to managing risk. SmartAsset’s asset allocation calculator can help you estimate how much of your portfolio should be invested in stocks, bonds and cash based on your risk tolerance and investor profile.

  • A financial advisor can help you set financial goals, select investments and manage your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three 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 goals, get started now.

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