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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.
