Key Takeaways
- A municipal bond is a debt instrument issued by states and local municipalities looking to raise money to support their operations and fund projects that are designed to benefit the public.
- Most municipal bonds pay interest periodically until they mature. The payments are referred to as coupons.
- At the highest level, municipal bonds are categorized based on their tax treatment. Taxable municipal bonds are subject to federal income tax, but tax-exempt bonds are not.
- You can invest in municipal bonds through either the primary or secondary market.
What Are Municipal Bonds?
Municipal bonds are debt securities issued by states and local municipalities to retail and institutional investors, who are commonly referred to as bondholders. The debt is issued to support the government entities’ operations and fund special projects designed to benefit the public.
Municipal bond debts are repaid upon maturity, which can occur anywhere from a few years to over 10 years after issuance. In the meantime, bondholders usually receive fixed-rate interest payments on the amounts (par values) loaned. The interest payments, which are referred to as coupons, are typically paid every six months until maturity — but the frequency can vary from one municipal issue to the next.
Some municipal bonds pay interest monthly, and some pay interest annually. Others, referred to as zero-coupon bonds, pay no periodic interest. The interest compensation on these securities is provided via a discount from the par value.
Municipal bonds are a safe investment to add to help balance a portfolio. Be aware that not all municipal bonds are 100% tax exempt.
Timothy Li, MBABusiness Finance ManagerTimothy Li, MBA, has dedicated his career to increasing profitability for his clients, including Fortune 500 companies. Timothy currently serves as a business finance manager where he researches ways to increase profitability within the supply chain, logistics and sales departments.
What Are the Types of Municipal Bonds?
At the highest level, municipal bonds are categorized based on their tax treatment. Tax-exempt municipal bonds are exempt from federal income tax, as well as state and local income tax if you purchase a bond issued in the state you reside. Taxable municipal bonds are subject to federal income tax but may be exempt from state and local income tax if you purchase a bond issued in the state you reside.
The interest income from certain tax-exempt municipal bonds must be included when computing the alternative minimum tax (AMT). If you are subject to this tax, consult with a tax professional to make sense of things.
Beyond this high-level distinction, municipal bonds are classified based on the origin of their cash flows.
- General Obligation Bonds
- General obligation bonds are issued to raise funds to cover wide-ranging operating costs and are supported by the taxing authority of the issuer.
- Revenue Bonds
- Revenue bonds are issued to finance specific infrastructure projects and are supported by the revenue generated by those projects.
Common Types of Municipal Bonds
General obligation bonds are usually less risky than revenue bonds because the cash flows supporting them are comparatively more predictable and reliable. That said, credit quality can vary widely for general obligation and revenue bonds. As a result, conservative investors should always strive to put their money into highly rated, investment grade issues.
A municipal bond default occurs when one or more terms in a bond agreement are violated by the issuer. Generally, this happens when a payment is made late or missed entirely. When this occurs, bondholders have the right to seek legal action against the issuer to mitigate their losses.
How To Buy and Sell Municipal Bonds
You can invest in municipal bonds via the primary market or the secondary market. The primary market is the forum where states and local municipalities issue debt directly to investors in exchange for cash. The secondary market is the forum where investors trade previously issued municipal securities with each other.
Most retail investors buy and sell municipal bonds in the secondary market through a financial advisor or by making trades directly through a self-service brokerage account. That said, secondary market participation does not always involve trading individual municipal bonds.
In many cases, investors gain exposure to municipal bonds via actively managed mutual funds and passively managed index funds and exchange-traded funds (ETFs). These vehicles provide share-based ownership of an underlying basket of municipal bonds and make periodic interest payments to shareholders.
When buying individual municipal bond issues, the minimum investment is typically $5,000. Alternatively, when investing in municipal bonds via a fund-style vehicle, the minimum investment can be less than $100.
What Are the Benefits of Investing in Municipal Bonds?
Municipal bonds offer a relatively safe way to generate a consistent stream of income and reduce your tax liability, assuming you maintain a quality bias and invest in tax-exempt municipals. Additionally, they can help you achieve meaningful diversification and stabilize an investment portfolio holding volatile assets, such as stocks.
That said, some municipal bond issues are illiquid and difficult to sell at a reasonable price. Many others are highly sensitive to inflation and interest rate changes. When investing in these high-risk issues, do so with unwavering restraint.
How Do Municipal Bonds Compare to Other Investments?
The closest alternatives to municipal bonds are other high-quality bonds, such as U.S. Treasury bonds, U.S. government agency bonds (Fannie Mae, Ginnie Mae, etc.) and investment grade corporate bonds. Like municipal bonds, these instruments exhibit stability and provide reliable income streams.
That said, municipal bonds can expose investors to more credit risk than U.S. Treasury and government agency bonds. Fortunately, they usually compensate investors for this with higher after-tax bond yields.
Read More: Corporate Bonds
How To Compare Tax-Exempt Bond Yields to Taxable Bond Yields
The best way to determine whether a tax-exempt municipal bond offers a good yield relative to a comparable risk U.S. Treasury bond, U.S. government agency bond or investment grade corporate bond is through a metric known as the tax-equivalent bond yield. It is the return a taxable bond would need to produce to equal the yield on a tax-exempt municipal bond. The calculation is as follows:
For example, assume your marginal income tax rate is 25%, and you have an opportunity to invest in a tax-exempt municipal bond yielding 3.50%. In this situation, the tax-equivalent bond yield is 4.67% (.035 ÷ (1 – 0.25)). Essentially, this means a comparable risk taxable bond that has a yield higher than 4.67% is economically superior to the tax-exempt issue.
Are Municipal Bonds a Good Investment?
Municipal bonds are not inherently good or bad investments. Their suitability depends on an investor’s unique circumstances, risk-return profile and tax position.
Generally, municipal bonds (particularly, tax-exempt municipal bonds) are a good investment for income-oriented investors interested in minimizing taxable income and adding stability to their investment portfolios. However, they can be a poor investment for strongly growth-oriented investors with long time horizons and the ability to endure market volatility. For them, the opportunity cost of not investing in higher-returning assets is significant.
Nevertheless, municipal bonds can make sense whether your investing horizon is short or long. Under the right conditions, they can be highly accretive to your wealth by adding tax-free income and enhancing portfolio efficiency (return per unit of risk). To assess your specific situation and personal finance goals, consult with a fiduciary financial advisor.
Frequently Asked Questions About Municipal Bonds
The best way to evaluate the riskiness of a municipal bond is to reference its credit rating, which is assigned by one or more of the three main bond rating agencies: Fitch, Moody’s and S&P Global. Each rating agency has its own methodology to establish ratings, but the objective is the same: to provide an indication of the likelihood that bondholders will receive promised interest payments and be repaid in full at maturity. The safest municipal bonds are assigned investment grade ratings; the riskiest bonds are assigned non-investment grade ratings.
Yes. If you invest in a bond that defaults, you can lose money. This is very rare for investment grade issues but can happen much more frequently with non-investment grade issues.
Typically, the interest from municipal bonds is exempt from ordinary federal income tax as well as state and local income tax (if you purchase a bond issued in the state you reside). The interest from taxable municipal bonds is subject to federal income tax but may be exempt from state and local income tax (if you purchase a bond issued in the state you reside).
When evaluating the attractiveness of a tax-exempt municipal bond with a comparable risk taxable bond, the best approach is to utilize the tax-equivalent bond yield metric. It indicates the return a taxable bond would need to produce to equal the yield on a tax-exempt municipal bond.
Investment grade municipal bonds are comparable to other high-quality fixed-income instruments, such as U.S. Treasury bonds, U.S. government agency bonds, investment grade corporate bonds and fixed annuities. All these investments are relatively stable and provide reliable streams of income. However, their tax profiles differ, and they exhibit varying degrees of liquidity, credit risk and interest rate risk.
Editor Malori Malone contributed to this article.
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