How to Invest in Municipal Bonds:
Municipal bonds—or muni bonds—are fixed-income securities issued by local or state governments to fund public projects. When planning your investment portfolio, municipal bonds are one way to add tax efficiency to the mix. Here’s what you need to know about tax-free municipal bonds and how they can be used in your portfolio.
What Are Municipal Bonds?
When you invest in a municipal bond, you are lending money to a local or state government with the expectation that you’ll be paid interest over the term of the bond. When the muni bond matures, you expect to be repaid the full value of the principal.
Municipal bonds have been used to fund large-scale projects throughout the history of the United States. Starting in the early 19th century, states and local governments began issuing muni bonds to help finance the canals, railroads, and roads needed for the country’s westward expansion. As of 2019, the municipal bond market comprises $3.9 trillion in outstanding debt. That’s smaller than the $9.6 trillion corporate bond market—but municipal bonds offer a very wide range of investment opportunities, with around 50,000 issuers, compared to only about 6,000 corporate bond issuers.
In many cases, municipal bonds earn interest tax-free. Depending on the issuer or the municipal bond, you may be able to avoid paying federal or state taxes on all or a portion of the interest you earn. When you invest in municipal bonds, you can improve the tax efficiency of your portfolio, earn a relatively safe return, and help communities fund investments like roads, schools, and hospitals.
Types of Municipal Bonds
There are two types of municipal bonds: general obligation bonds and revenue bonds. No matter which type you invest in, they are usually considered low-risk investments, with a very high expectation that you’ll be able to recoup your investment plus interest.
However, it’s important to note that municipal bond rates might be lower than the potential returns you might get from riskier assets, like stocks. It’s best to consider municipal bonds as part of a long-term investment strategy with the potential to provide reliable income and tax efficiency.
What Are General Obligation Bonds?
General obligation bonds are a type of municipal bond where the issuer secures the debt with its taxation authority. In many cases, general obligation bonds are issued to raise funds to complete a large project, after which a government agency repays the debt over time with tax revenue.
There are two different types of tax pledges backing general obligation bonds:
- Limited tax pledges: Annual taxes are charged within the limits of existing laws and are used to ensure the debt will be paid.
- Unlimited tax pledges: Taxes are levied in a way that ensures the debt will be repaid, without a limit placed on the tax rate or the amount raised.
School districts, as well as state and local governments, frequently issue general obligation bonds.
What Are Revenue Bonds?
Revenue bonds are often used to finance ongoing projects, such as infrastructure upgrades. Unlike general obligation bonds, revenue bonds aren’t tied directly to a general taxing authority. Instead, the taxes or fees charged are designed specifically to ensure the muni bond debt will be repaid. You can break revenue bonds into two main types:
- Tax revenue municipal bonds. These revenue bonds receive backing from a portion of ongoing taxes. For example, some of the income from a utility tax, resort/hotel tax, excise tax or sales tax might be earmarked to pay off the debt.
- Enterprise municipal bonds. Rather than relying on taxes, enterprise revenue bonds focus more on the income raised by the costs of using something. Often, these types of bonds are issued by entities that charge for a service, such as utilities, airports, hospitals, and even sewer authorities. The income generated by payers is used to secure the debt.
For example, a city looking to create a convention district might issue municipal bonds and then earmark a portion of the money raised through a hotel occupancy tax to secure a tax revenue bond. On the other hand, a city might secure an enterprise revenue bond to improve and maintain a stretch of interstate with a toll charge.
Either way, expected ongoing revenue streams are used to back the bonds rather than the general tax base.
How Are Municipal Bonds Taxed?
Municipal bonds are often referred to as tax-free because they come with favorable tax treatment as compared to other types of bonds. In many cases, the interest on bonds issued by state and local governments is not subject to federal taxation. With corporate bonds, on the other hand, you usually pay regular income taxes on interest income.
Many municipal bonds are exempt from state and local taxes if they are held by residents of the locality or state in question. There are limitations to muni bonds’ tax advantages, though. For example, if you’re subject to the alternative minimum tax (AMT), you might not be able to completely avoid taxes on muni bonds. However, for many investors, municipal bonds can be tax-free investments that add to the tax efficiency of their portfolios.
How Much Do Municipal Bonds Earn?
Muni bonds often have lower yields than corporate bonds and other taxable bonds. Municipal bond rates are lower because they are considered relatively safe as compared to other assets. However, it’s important to note that the tax efficiency of municipal bonds also plays a role in their desirability.
For example, let’s say you’re in the 24% federal income tax bracket. You find a municipal bond with a tax-exempt yield of 5%. To get the same after-tax income benefit from a taxable bond, you’d need a yield of 6.6%. The difference is even more pronounced at a higher tax bracket. In the 35% tax bracket, you’d need a yield of 7.7% to see the same benefit in a taxable bond.
Using Tax-Free Municipal Bonds in Your Portfolio
When deciding how to invest in municipal bonds, it’s important to consider your long-term strategy. Muni bonds are appropriate for a taxable investment strategy but not for tax-advantaged retirement accounts. A financial advisor can help you figure out where these investments should fit into your portfolio and where they might benefit you as an income strategy.
Keep in mind that when investing in municipal bonds via mutual funds or exchange-traded funds (ETFs), you’ll be subject to capital gains taxes when you sell your shares. Additionally, if you buy and sell municipal bonds on the secondary market, there may be an element of capital gain or loss, and appropriate taxes apply.
Municipal bonds are not appropriate investments for tax-advantaged retirement accounts, like IRAs. Because municipal bonds already provide many investors with tax breaks, keeping them in an account like a traditional IRA can be counter-productive. Distributions from a traditional 401(k) or a traditional IRA are taxed at your current marginal rate, so the sale of muni bonds to fund such distributions would destroy their tax efficiency.
How to Buy Municipal Bonds
You can open a self-directed account with an online broker to trade municipal bonds. Buying and selling individual municipal bonds requires you to do your own research and be aware of transaction costs. In addition, you must be aware of the default risk involved with the munis you’re purchasing. You can also buy and sell municipal bonds in the secondary market, rather than purchasing new issues and holding them until they mature.
If you’re less confident in your ability to negotiate buying and selling bonds, talk to a financial advisor about muni bonds. An advisor can help you understand the tax implications of municipal bonds and how they can fit into your overall investment portfolio.
Alternatively, you can buy municipal bonds via mutual funds and exchange-traded funds (ETFs). However, it’s important to note that with any type of municipal bond fund, you don’t actually directly own the bond.
Municipal Bond Mutual Funds
Municipal bond mutual funds are a great way to diversify your exposure to muni bonds while reaping the potential tax efficiency. Like with any other mutual fund, fund managers buy a wide range of municipal bonds to help meet the goals of the fund.
You still get tax advantages with a municipal bond mutual fund, although the range of bonds owned by a given fund might provide fewer direct tax benefits. At a minimum, some income from muni bond mutual funds will be exempt from federal taxes, and, depending on where you live, some may also be free of state or even local taxes.
Using a municipal bond mutual fund can help you diversify your holdings and create less of a need to manage several different bond holdings on your own, but you also have to pay the usual mutual fund fees—such as expense ratios and potential sales fees—and your returns are subject to changes in the market value of the bonds, rather than relying as heavily on the yield.
Municipal Bond ETFs
If you like the idea of investing in a bond mutual fund for the diversity and ease, but you don’t like the idea of only transacting business once a day or dealing with some of the other limitations of mutual funds, a municipal bond ETF might make sense. Exchange-traded funds are traded on the market like stocks, making it easy to gain exposure to municipal bonds without actually owning them.
Like with mutual funds, income from municipal bond ETFs is usually tax-exempt at the federal level and may come with advantages at the state and local levels as well. Even though there is generally more volatility when it comes to price, ETFs are one of the easiest ways to invest in municipal bonds.