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Investing in Municipal Bonds: Pros and Cons to Consider

Learn about the pros and cons of investing in municipal bonds, which offer some tax advantages compared to other types of investments.

If you’re looking to invest your money while minimizing risk, you have a few options.

Typically, when building an investment portfolio, bonds are often the go-to option for lowering your risk.

However, bonds come in many forms. One type of bond often heard in the industry is municipal bonds.

They can be an effective way to earn steady returns while diversifying your portfolio. And, they have a minimal probability of default, so there’s little risk.

Here’s what you need to know about how to invest in municipal bonds. 

What Are Municipal Bonds?

Municipal bonds, often called munis, are debt securities that are issued by government entities like states, cities, and counties.

These entities sell municipal bonds to raise money for regular operations and for special projects like building new schools or improving roadways. 

Now:

When you purchase a municipal bond, you’re acting as a lender. You’re lending money to the bond issuer. In return, the issuer pays you interest plus the principal over time

Municipal bonds usually have maturity dates — the date when the issuer must repay the principal — that are years away. 

Tax advantages

Municipal bonds are typically exempt from federal income taxes. And, they may even be exempt from state and local taxes, too. 

Municipal bonds are especially advantageous for those with high incomes who live in states with high income taxes, such as New York or Connecticut.

If you have a lower income or live in a state that doesn’t have state income taxes, such as Florida, municipal bonds are less attractive.

How do they work?

If you want to invest in municipal bonds, you can buy individual bonds or invest in mutual funds made up of municipal bonds.

Single shares and bonds in mutual funds can be purchased through a brokerage firm, much like stocks. 

The best part:

Once you buy municipal bonds, you can enjoy steady returns.

Municipal bonds tend to have fixed interest rates, so you’ll get regular income payments semi-annually until the bond reaches its maturity date and the issuer repays the principal. 

It can take years or even decades for the bond to reach maturity, so it can be a dependable source of income.

Bonds with longer terms tend to have higher interest rates because they’re more likely to be affected by inflation rates and market fluctuations.

Types of Municipal Bonds

There are two main types of municipal bonds: 

General obligation bonds

These bonds are issued by states, counties, and cities. They are not secured by any assets.

Instead, the bonds are backed by the credit of the issuer.

If necessary, the state, county, or city can tax residents to get the money to pay back bondholders.

Revenue bonds

Unlike general obligation bonds, revenue bonds are not backed by the government’s taxing ability. Instead, they’re secured by the revenue from projects, like building highway toll booths.

Pros

If you want to diversify your portfolio, there are several advantages to investing in municipal bonds. 

1. They’re usually exempt from federal income tax

Municipal bonds are a very popular source of tax-free income. They are fixed-income investments, and they can give you higher returns than some other options.

Even better:

The interest on a municipal bonds is usually exempt from federal income taxes. It may even be exempt from state and local taxes, too. That perk allows you to keep more of your income.

2. Munis are less risky than stocks

Compared to other asset classes, municipal bonds are a low volatility investment option.

In recent years, defaults on municipal bonds have decreased, so there’s less risk of losing your money than if you invested by buying stocks.

3. Municipal bonds provide a steady stream of income

Because munis have fixed interest rates, you’ll receive routine payments.

Payments are normally disbursed every six months.

Terms can range from one to 30 years, providing you with a steady stream of reliable income.

Cons

While investing in municipal bonds can be a smart choice, there are some downsides to consider. 

1. Munis may have low yields

Compared to the returns you can get with stocks, exchange-traded funds, or mutual funds, the interest rate on municipal bonds is low.

As the inflation rate rises, municipal bonds will have a lower market value. 

2. Opportunity cost

If you’re in a lower tax bracket, the tax advantages of municipal bonds won’t be as worthwhile as it would be if you were in a higher tax bracket.

If that’s the case, you may be better off investing your money in other securities to get a higher yield.

3. They may not be liquid

If you need to get a hold of cash, you should know that you may run into liquidity issues with municipal bonds.

You may not be able to find an active market for your bonds, preventing you from selling them when you want at the price you’d expect.

How to Invest in Municipal Bonds

There are two main ways to invest in municipal bonds:

  • purchase them directly
  • invest in a municipal bond fund

If you opt to buy municipal bonds directly, you can buy them from the state, county, or city by working with a broker or local bank. 

If you want a broader range of investments, consider investing your money in a municipal bond fund instead.

With this approach, you get instant diversification in dozens or even hundreds of different municipal bonds.

Plus, municipal bond funds are more liquid than individual bonds, so you can sell your bonds more quickly.

1. Identify the fund

The very first step is to look for the municipal bond fund in which you'd like to invest.

It's important for finding the brokerage that actually offers this particular bond fund as an investment option.

2. Open a brokerage account

When you find a brokerage to offers that bond fund for investment, it's time to open an account.

You'll have the option to open a regular, taxable brokerage account. Or, you might consider an IRA if you don't already have one (assuming you qualify for 

3. Place an order

You'll need the ticker symbol of the municipal bond and then you can make a buy order.

If you are purchasing a bond mutual fund, do note that the end-of-day market price will be used. If you are buying a bond ETF, you're paying the market price at the time the order was placed.

How They Fit in Your Portfolio

Because municipal bonds are usually exempt from federal and even state taxes, they can be an asset to your portfolio. Investing in municipal bonds can help you generate interest and steady income. 

However, municipal bonds do have lower returns than you can get with other types of investments, such as exchange-traded funds or stocks.

That said:

When you’re young and saving for your future, it probably doesn’t make sense to invest most of your money in municipal bonds; you won’t earn enough returns for your retirement. 

But when you’re closer to retirement age, shifting your asset allocation to include municipal bonds can help preserve your capital while continuing to earn interest. 

If you don’t want to handle your investment allocation yourself, consider using a robo-advisor. Robo-advisors will ask you questions about your goals and risk tolerance and will invest your money accordingly.

As you get closer to your target retirement date, the robo-advisor will adjust your allocations to decrease your portfolio’s risk level.

Investing your money

Municipal bonds are a relatively safe investment option, but even munis have some level of risk.

They do offer tax advantages and steady income, so they have a place in your portfolio.

However, make sure you do your research before investing to make sure you’re diversifying your portfolio appropriately.

If you need help, consider hiring a financial professional or using a robo-advisor to handle your investments for you.