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What are Municipal Bonds? Everything to Know

Luisa Rollenhagen

Luisa Rollenhagen is a journalist and investor who writes about financial planning for Wealthsimple. She is a past winner of the David James Burrell Prize for journalistic achievement and her work has been published in GQ Magazine and BuzzFeed. Luisa earned her M.A. in Journalism at New York University and is now based in Berlin, Germany.

A bond is a type of loan that you’re giving to a corporation or government (via your investment). A bond comes with an end date by which the totality of the loan will be paid back to you, while also entitling you to receive interest payments on that loan, usually twice a year. There are short-term bonds where the amount is paid back within one to three years, and longer-term ones that can last over ten years. This time period is known as the bond’s “maturity level.” This regular payment of a fixed interest rate is why bonds are usually referred to as fixed income instruments—although variable interest rates exist.

Municipal bonds—or “munis,” as those in the know call them—are the kinds of bonds that are issued by governments as opposed to corporations. Municipal bonds can be issued by states, cities, counties, or other types of local governments. They function as a loan because the money you invest in the bonds is then used by local government to pay for infrastructure and government programs and to generate a cash flow.

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Bonds tend to be thought of as a low-risk, low-reward investment, ideal for investors looking to preserve capital and enjoy a small but steady stream of income. This is because it’s historically been quite unusual for cities to default on these types of loans. Plus, the interest you gain is not taxed by the federal government.

The most common way to invest in munis is to buy them from a registered municipal bond seller or to own them indirectly through a municipal bond fund. According to the U.S. Securities and Exchange Commission, there are two types of municipal bonds that are most readily available to investors:

  • General obligation bonds. These are the most common types of municipal bonds issued, and they refer to bonds where the borrower, ie. the government entity, must repay the full amount invested into the bond back to you.

  • Revenue bonds. These types of bonds are repaid by government entities through revenue generated from a specific project or source, such as highway tolls or sports arenas. The risk with these types of bonds is that they can be “non-recourse,” meaning that if the revenue stream dries up, then you’re out of luck—the bond issuer doesn’t have to pay you.

There are also bonds issued by the government on behalf of private groups, such as non-profit colleges or hospitals. However, if these private groups can’t pay back the original debt, then the government isn’t liable for the outstanding amount.

unicipal bonds are generally considered to be low-risk. And low-reward: Tax-free municipal bonds can yield annual rates between 2 and 5%.

Taxed municipal bonds vs. tax-free municipal bonds

Most municipal bonds are tax-free, meaning that you don’t have to pay federal tax on any income you make from the bond’s returns. And in some cases, depending on where the bond was issued, you might be exempt from state or local income tax as well. And because most municipal bonds are tax-free, they tend to be a popular choice for investors in higher income brackets since they can provide a higher after-tax yield than similar taxable investments.

There are, however, a couple of tax considerations you’ll need to keep in mind when investing in municipal bonds. If you purchase a state bond that’s from a different state than the one you live in, then your home state might tax the income you earn from the interest. It’s also important to note that any capital gains from the sale of a municipal bond are still subject to capital gains taxation. So if you buy a municipal bond for $5,000 and later sell it for $7,000, you still have to pay capital gains tax on those $2,000.

Pros & cons of municipal bonds

While the tax perks associated with municipal bonds are definitely one of their more appealing characteristics for investors, there are also a few disadvantages that you should keep in mind before you start stuffing your portfolio with munis.

Pros

  • No federal taxation. Federal taxes can really take out a chunk of your interest earnings, but with municipal bonds, whatever interest you’re gaining is all yours. This benefit is particularly useful if you’re in a higher tax bracket or want to generate a tax-free stream of income.

  • No state and local taxation (in some cases). If you buy state bonds from the state you live in, there’s a good chance you’ll be exempt from state and local income taxes on the interest gained.

  • Low risk. Because municipal bonds are considered to be a fixed-income asset—where returns are paid out in regular intervals—they’re usually pretty low-risk and lack the volatility of stocks. Historically, munis have been one of the more stable assets to invest in, since very few cities have defaulted on their loans.

  • Investing in your community. On a broader level, buying municipal bonds can be an efficient way to give back to your state or county and promote the improvement of schools, hospitals, roads, and more. Sure, investing in a Fortune 500 company sounds appealing, but there’s just something about helping your city fix up its schools that feels a little more rewarding, no?

Cons

  • Low interest rates. Because governments don’t generate the same type of revenue as corporations, you’re going to get much lower interest rates than you would with corporate bonds.

    In some cases, if you’re in a low-enough tax bracket that the tax benefits don’t outweigh the low interest rates of municipal bonds, you might want to consider parking your money in a high-interest savings account instead, where you won’t have to worry about opening an investing account or figure out how to incorporate bonds into your portfolio.

  • Inability to keep up with inflation. As mentioned before, it’s not uncommon for municipal bonds to offer annual rates of about 2%. And if you’ve placed your money in a bond with a long-term maturity level—10 years or more—there’s a good chance that those rates won’t be able to keep up with annual inflation rates. Which means that in the long term, inflation might eat away at some of your profits.

  • Possible losses from fixed maturity levels. By investing in munis, you’re locking away your money for a specific period of time. So if something happens during that time—say, an emergency, or a similar bond with a higher interest rate comes along—you can certainly sell a bond before it reaches its maturity level, but then you’re only receiving the market value of the bond at the point of selling, and this could be significantly lower than what you paid for originally.

    If, on the other hand, you hold onto the muni until its maturity date is reached, then you’re guaranteed—at a minimum—the original amount you paid for it. Selling before a bond’s maturity date also means forgoing any future interest you’d earn on the bond.

How and where to buy municipal bonds

You can buy municipal bonds the same way you can buy other types of bonds.

  • Choose your seller. In some cases, you can buy individual munis directly from the municipality you want to invest in. Otherwise you can purchase municipal bonds through bond dealers, through a discount online brokerage, or through an investment platform.

  • Decide what kind of bonds you want to buy. As is the case with any investment decision, research is key. Obviously, if you want to help your local government with a specific project you already know about, then your decision will be more targeted, but if you want to see what’s out there, the Electronic Municipal Market Access website might be a good source. Here you can find a bond’s type, yield, and maturity. It also gives you the bond’s credit quality, risk factors, and audited financial statements.

  • Keep diversification in mind. Your portfolio should never rely too heavily on one kind of asset, and this includes municipal bonds. That’s why a bond fund can provide access to multiple municipal bonds, as well as other kinds of bonds, to spread out your investment.

    The best part? If you’re unsure of how to go about this, automated investment services (also known as robo-advisors) will work to create personalized portfolios for you that include an array of bond ETFs (hello, low costs and high diversification) as part of their portfolios. The best of these services feature no minimum investment. to open any type of account.

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Last Updated September 24, 2019

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