What Are Municipal Bonds?

What Is a Municipal Bond?

A municipal bond is a type of debt security issued by states, cities, counties and other government entities as a way of funding public projects: schools, parks, sewer systems, public transportation, hospitals and the like.

When you buy municipal bonds, you act as a creditor, lending money to a municipality. You get paid back for your initial investment once the bond reaches maturity, and you'll also be paid a steady rate of interest throughout the bond's term. One of the notable features of munis is that you may not be required to pay federal, state or local taxes on the interest you earn.

Types of Municipal Bonds

There are two main types of municipal bonds. Which category a muni falls into comes down to where the payments bondholders receive come from—the source of their interest payments and repayment of their principal investment.

• General obligation bonds (or GO bonds) are issued by government entities, such as state or local municipalities, and "backed by the full faith and credit" of that entity. These types of bonds are usually secured by the taxing authority of the government, rather than by a specific source of revenue.
• Revenue bonds are bonds that use revenue from a specific project, such as a toll road, to pay back bondholders. If the project doesn't generate the expected revenue, the investor could end up not recouping their principal investment. That said, revenue munis still tend to have a high credit rating (meaning the risk of default is low), and they may also offer perks like higher interest rates and more opportunities for diversification.

Pros and Cons of Municipal Bonds

Before you decide to buy municipal bonds, consider these pros and cons.

Pros of Municipal Bonds

• Little risk: Municipal bonds are an asset that you can use to preserve wealth by taking on very little risk and earning a predictable amount of interest over a set period of time, often paid out semiannually.
• Tax benefits: Interest earned from investing in municipal bonds is typically free from federal income tax. What's more, if you buy munis issued in the state you live in, you may also be exempt from paying state or local taxes on your earnings. This can make munis a great way to generate a small amount of passive income while minimizing taxes.
• Diversified holdings: Investing in a number of different asset classes can help you temper risk in your portfolio. You may already hold stocks and corporate bonds in your portfolio, for example. Adding munis to the mix is an opportunity to diversify further.
• Invest for public good: If you like to put your money where it has the chance to make a positive impact, you might like knowing that money you place in munis is used to fund infrastructure such as bridges, hospitals, schools and other projects that have a tangible, positive impact for people living in a community.

Cons of Municipal Bonds

• Limited returns: Bonds in general are a fixed income investment with low risk and correspondingly low, predictable returns. But municipal bonds tend to have even more conservative rates than other fixed income assets, such as corporate bonds. On the other hand, while you may not get a high coupon rate when you buy munis, you should factor in the value of tax exemptions when evaluating the expected returns for an asset.
• Illiquidity: Munis have maturities that can range from less than a year to as many as 30 years. In other words, they aren't highly liquid assets. That means they may be a good place to house long-term savings, but they aren't a great place for your emergency fund, for example.
• Expensive minimum investment: Municipal bonds are typically sold in increments of $5,000. That means it's only a good investment option for you if you have a fairly sizable chunk of change that you want to put into bonds. That said, you can get around this by investing in muni funds—more on this below.
• Default risk: As in the case of any bond, it's possible that the entity you lend to could end up unable to repay the debt, resulting in default. That said, as an asset class overall, munis have a very low risk of default—less than 1% over the 10-year period ending December 2021, according to data from Vanguard.
• Call risk: Many munis are "callable," meaning the bond issuer could repay the bondholder before the bond reaches its maturity. This is more common in a falling interest rate environment because the bond issuer will save money by calling the bond (in other words, returning your principal payment). As an investor, this can mean losing out on some of the money you'd have earned if you'd been able to keep your money invested until maturity.

How to Invest in Municipal Bonds

There are three main ways to invest in municipal bonds:

1. Buy Individual Municipal Bonds

One option is to select individual municipal bonds and purchase them through a brokerage. Then, you can hold your bonds until maturity and collect regular interest.

If you go this route, you'll need to do some research to find the munis that work the best for your portfolio, factoring in interest, tax benefits, term length and the issuer's credit rating. Also, if you want to generate a steady stream of income, consider buying multiple munis with different maturities to create a bond ladder.

2. Invest in Muni Mutual Funds

If you want to invest widely in municipal bonds, consider muni mutual funds. Unlike individual municipal bonds, which are typically sold in increments of $5,000, initial investment requirements for muni funds could be $500 or less.

Muni mutual funds allow you to pool your money with other investors' to invest in municipal bonds with a specific strategy or goal. For example, there are state-specific muni mutual funds designed to invest in bonds that are tax-free for residents within that state. So, for example, if you live in New York, you could minimize taxes by investing in New York municipal bond mutual funds.

There are also muni mutual funds that invest in munis throughout the country, which can add diversification. While you may owe some taxes on your earnings, you'll still benefit from federal tax exemptions.

Muni funds are also set up to invest for a specific timeframe or risk tolerance. Some funds are balanced to generate the highest amount of income possible now (without taking on undue risk), while others are balanced for long-term preservation of capital. Other funds, called intermediate-term funds, fall somewhere in between.

3. Invest in Muni Exchange-Traded Funds (ETFs)

Similar to muni mutual funds, muni ETFs are a way to invest widely in municipal bonds that meet certain criteria. For example, there are muni ETFs designed to be of the most benefit to residents in a given state—a resident of California might choose to invest in a California muni ETF for the state tax exemptions. There are also national muni ETFs, high-yield muni ETFs and muni ETFs selective of short-, intermediate- or long-term bonds.

The key difference between muni ETFs and muni mutual funds is that muni ETFs are generally more liquid and, often, charge lower fees than muni mutual funds. And, as another benefit, you don't need to come up with a specific minimum investment to invest in muni ETFs. Instead, you pay market price for ETFs through stock exchanges.

The Bottom Line

Municipal bonds may have a place in your portfolio if your aim is to preserve wealth while minimizing taxes. Keep in mind that munis aren't a good choice for your retirement account, such as your 401(k) or individual retirement account: Earnings from municipal bonds are already exempt from federal taxes, so you don't gain anything by placing them in tax-advantaged accounts.

If you're unsure of how to fit investing in bonds into your overall strategy for funding both your short-term goals and long-term goals for retirement, consider working with a financial advisor. They can help you review your personal financial situation to come up with an individualized strategy for building and preserving wealth.