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Municipal bonds exist to fund state and local government spending. Historically, if you were a municipal government and wanted to build things such as roads, bridges, airports, affordable housing, or public utilities, you could borrow from the public using municipal bonds to get money to pay for the projects. Through these bonds, investors give the government money to spend on the project in exchange for a promise from the government that it will pay all the money back at some later maturity date plus interest payments along the way (commonly paid twice a year).
It turns out that loaning state and local governments money is usually a really good investment. They almost always pay the money back, they almost always make their interest payments on time, and they often give their investors special financial treatment. For example, municipal bond income is often exempt from taxes.
Municipal bond income has been exempted from the federal income tax since the income tax’s original enactment in 1913. The tax code writers seemed to believe that state and local governments should not tax the federal government, and the federal government should not tax state and local governments. This relationship has resulted in the following typical outcomes:
- Bonds issued by federal governments are generally exempt from state and local taxes.
- Bonds issued by state or local governments are generally exempt from federal taxes.
Additionally, municipal bond income is usually free from state income tax in the state where the bond was issued. However, keep in mind that:
- Some states do tax interest on their own municipal bonds.
- Some states don't tax interest on municipal bonds from any state.
- Sometimes a state that usually taxes interest on municipal bonds will exempt specific bonds at the time it issues them.
- Depending on the laws where you live, income from municipal bonds also may be exempt from local taxes. Review with a tax advisor for more information about the rules in your state.
The two most common types of municipal bonds are general obligation and revenue bonds:
- General obligation bonds are issued by states, cities or counties and not secured by any assets. Instead, general obligation bonds are backed by the “full faith and credit” of the issuer, which has the power to tax residents to pay the bondholders.
- Revenue bonds are not backed by a government’s general taxing power but by revenues from a specific project or source, such as highway tolls or certain sales, fuel, or hotel occupancy taxes. Some revenue bonds are “non-recourse”, meaning that if the revenue stream dries up, the bondholders do not have a claim on the underlying revenue source.
How to buy municipal bonds
You can access municipal bonds through direct ownership, bond mutual fund, and bond ETF.
Direct ownership: Through a brokerage account with a platform like Fidelity or Vanguard, you can purchase individual municipal bonds. You will need to assess the quality and price yourself (or pay for someone to). However, once your portfolio is assembled, you may be able to let it run with limited additional input, simply collecting the interest payments.
Bond mutual fund: Mutual funds that own bonds offer broad diversification compared to simply owning the bonds directly. Typically, a bond fund manager will buy and sell according to their understanding of market conditions and will rarely hold the bonds until maturity. Unlike individual bond securities, bond funds do not have a maturity date for the repayment of their principal; therefore, the principal amount invested may fluctuate over time.
Bond ETF: Bond exchange-traded funds (ETFs) are a collection of bonds that can be traded on an exchange. The ETF aspect adds diversity to your portfolio while the fact that the underlying assets are bonds will generate potential income, and offer inflation protection, higher yields, and tax advantages. While some bond ETFs do have maturity dates, most have an open-ended lifespan.
Reasons to consider municipal bonds
- Interest income is generally exempt from federal taxes
- Very stable source of income
- Low level of default risk relative to other bond types
Primary risks of investing in municipal bonds (arranged alphabetically):
- Call risk refers to the potential for an issuer to repay a bond before its maturity date, something that an issuer may do if interest rates decline (but is less likely when interest rates are stable or moving higher). Many municipal bonds are “callable,” so investors who want to hold a municipal bond to maturity may find it paid off earlier than expected.
- Credit risk is the risk that the bond does not pay the interest and principal in full (i.e. the bond “defaults”). Credit ratings are available for many bonds, and seek to estimate the relative credit risk of a bond as compared with other bonds. While a high rating does not ensure that the bond has no chance of defaulting, municipal bonds generally are among the safest credit risks available in financial markets.
- Interest rate risk. Like all fixed-income securities, the market prices of municipal bonds are susceptible to fluctuations in interest rates. If interest rates rise, the market prices of existing bonds will typically decline, despite the lack of change to the bond itself. Bonds with longer maturities are generally more susceptible to changes in interest rates than bonds with shorter maturities.
- Inflation risk. Inflation is a general upward movement in prices. It reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. It also can lead to higher interest rates and, in turn, to a lower market value for existing bonds.
- Liquidity risk refers to the risk that investors won’t find an active market for the municipal bond, and so will be unable to buy or sell at the time or price that they want. Since the vast majority of municipal bonds are not traded on a regular basis, the market for a specific municipal bond may not be particularly liquid. With limited exceptions for some large more actively traded issues, the chances of finding a specific municipal bond in the secondary market at any given time are relatively small. Similarly, many investors buy municipal bonds to hold them rather than to trade them, so the market for specific bonds can be small and unpredictable.