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How to Invest in Municipal Bonds: Benefits and Risks

How to Invest in Municipal Bonds: Benefits and Risks

Municipal bonds are known as “Munis” and are issued by state and local governments to finance public projects such as schools, highways, and hospitals. Municipal bonds can be valuable for investors, particularly because of the tax benefits they offer.

These bonds are usually preferred due to their perceived safety and the possibility of earning tax-exempt income. But as in any investment, there are advantages and disadvantages that have to be taken into account.

What Are Municipal Bonds

Municipal bonds can be defined as a debt security offered by local or state governments or any of their affiliated companies.

If you purchase a municipal bond, it means that you are lending some cash to the municipal government, which has agreed to pay you back the face amount of the bond on a certain date plus periodic interest payment.

Municipal bonds can be divided into two categories.

  • General Obligation Bonds: These bonds are secured by the credit and the taxing power of the issuer and therefore are comparatively safe investments.
  • Revenue Bonds: These bonds are redeemed through funds that are produced from certain activities like construction of toll roads or provision of utilities. They have slightly higher credit risk than the GO bonds since their revenue depends on the success of the project.

The Advantages of Municipal Bonds

1. Tax-Exempt Income

Another advantage of participating in municipal bonds is that the interest received on them is usually not subjected to federal income tax. Sometimes, the interest is also free from state and local taxes making them to be referred to as tax-exempt bonds.

  • Federal Tax Exemption: Many municipal bonds provide interest income that is free from federal income tax.
  • State and Local Tax Exemption: If you reside in certain states, income from municipal bonds is also tax-free at the state and local level, especially if you invest in bonds of your home state.

This tax-exempt status can add a lot to the total returns for investors, especially those in the higher tax brackets. For instance, in the current 35% tax bracket, a tax free 3% municipal bond yield is equivalent to a taxable bond yielding about 4%.

2. Lower Risk Than Other Bonds

In general, municipal bonds are less risky than corporate bonds. Compared to corporations, government entities have a lower probability of defaulting. Furthermore, municipal bonds are relatively stable in the market and can be considered as safe for conservative investors.

  • Creditworthiness: Most of the Muni bonds issuers have high credit ratings, which means the bonds are safer investment than some corporate bonds.
  • Government Backing: General obligation bonds that are secured by the taxing authority of the issuer offer an additional layer of protection to investors.

3. Steady Income Stream

Municipal bonds offer fixed interest returns as a form of investment and can be a steady source of income. This is especially useful for those who own properties, such as retired individuals or investors who are looking for a steady stream of income.

  • Regular Interest Payments: Many municipal bonds have interest payments made twice a year, which can offer consistent cash flows to the investor.
  • Long-Term Security: Since these bonds are often long-term, they provide a consistent stream of income over the bond’s lifetime.

4. Diversification in Bond Investing

Municipal bonds remain a good chance to diversify your bond investments. For those who already have corporate or government bonds in their portfolio, including Munis can reduce investment risk and diversify between tax and tax-exempt income.

  • Portfolio Balance: Municipal bonds are useful to diversify a portfolio, especially when investing in stocks or high-risk corporate bonds.
  • Reduced Volatility: Municipal bonds are not as unpredictable as corporate bonds or stocks, which can be beneficial in diversifying the portfolio.

The Risks of Municipal Bonds

Although there are certain advantages of investing in municipal bonds, there are also certain disadvantages. Although Munis are not as risky as stocks, they are not a risk-free investment either like all other investment options.

1. Credit Risk

Despite the low incidence of municipal bond issuers defaulting, the fact is that they can do so. This is more prevalent with revenue bonds, which are issued with the expectation that the proceeds shall be recovered from the success of a particular project.

  • Default Risk: In the worst-case scenario, cities or municipalities may experience some form of financial turmoil that compromise bond repayments.
  • Rating Downgrades: Although a municipality may not default on its payments, its credit rating can be lowered, thus lowering the value of your investment.

2. Interest Rate Risk

It is important to note that like all bonds, Muni bonds are not immune to fluctuations in interest rates. If the interest rates go up, then the value of the existing bond also goes down. This is because newer bonds issued in a higher interest rate environment become more attractive to investors.

  • Price Fluctuations: If you wish to sell the bond before it matures, then you may have to sell it at a lower price if the interest rates have gone up since you bought the bond.
  • Long-Term Risk: Debt securities with longer maturity have higher interest rate risk and therefore have higher price risk.

3. Liquidity Risk

Municipal bonds are not very liquid investments, unlike other types of investments such as stocks. This means that it might be difficult to find a buyer when you want to sell your bonds, especially if they are not very popular or from the less popular issuers.

  • Market Availability: While more people invest in municipal bonds, smaller ones are not as popular and can be difficult to sell when the need arises.
  • Price Impact: The liquidity problem may compel you to sell the bond at a less preferred price especially during volatile financial markets.

4. Call Risk

Certain municipal bonds are issued with a call clause which enables the issuer to redeem the bond before the stated maturity. This can happen when the interest rate is low, and the issuer is able to find a new source of financing at a cheaper rate.

  • Loss of Income: If your bond is called, you will not receive interest anymore, which means you will have fewer income sources.
  • Reinvestment Risk: After a bond is called, it can be challenging to find another bond that will provide a similar yield especially in a lower interest rate environment.

Conclusion

Municipal bonds present many benefits, including tax-exempt bonds and lower risk, but it is crucial to evaluate the risks of investing in municipal bonds, including the interest rate risk, credit risk, and the issue of illiquidity.

If you are aware of the advantages and disadvantages of bond investing in Municipal bonds, then you can make the right decisions depending on your investment goals and risk appetite.

Municipal bonds can serve an important purpose in an investment portfolio whether you choose to invest directly, through a mutual fund or ETFs.