Municipal bonds, also known as munis, are issued by states, cities, counties and other government entities below the federal level in order to raise money for public improvements like highways, bridges, schools, hospitals, sewer systems, water treatment plants and other such projects.
From a simplistic view, municipal bonds as a whole are investments which are considered to involve more risk than Treasury bonds, but less risk than corporate bonds. Contrary to what you might think, some municipalities have defaulted on their obligations. These investments are not without risk.
It’s important to note that any municipality might not be creditworthy and put you at risk of default. In general, the lower the bond rating, the higher the interest paid. But beware. Don’t get suckered in by the promise of higher interest payments if the bond has a lousy rating.
Two Types of Municipal Bonds
There are two varieties of municipal bonds: General Obligation bonds (GO for short) and revenue bonds. GO bonds are backed by the issuer’s ability to collect taxes, while revenue bonds are issued by entities like water companies or sewage treatment plants that generate revenue over time, and then use this income to make interest payments and repay the loan in its entirety on the maturity date. A double-barreled credit is a municipal bond which is a blend of these two types. Both types of municipal bonds pay periodic interest every six months, or twice per year until the bond matures.
It is widely thought that GO bonds entail less risk than revenue bonds because GO bonds are backed by the issuer’s unlimited taxing authority. Another reason is because it is impossible to forecast revenues from an issuers’ enterprise with exact certainty, and it is these cash flows which back revenue bonds. In reality, neither of these points is really correct. Taxing authority is limited by political and economic factors in the real world. Though not precise to the penny looking out an indefinite period of time, many entities operate like well-run businesses, raising rates when costs are expected to increase. It is much more critical to examine a municipal bond more closely than simply choose between these categories.
Knowing the credit rating is helpful and important, but again, requires further analysis. In general, top-rated GOs have a strong tax base, a sustainable and diversified economy, low levels of current debt, and a history of sound fiscal management. High-quality revenue bonds stem from a key formula known as debt service coverage ratio. This is the amount of funds available to make principal and interest payments to bond holders compared to the actual amount paid. A ratio of five or six is required for AAA ratings, but a ratio of two is still considered favorable. Be sure to analyze any potential bond holding carefully and not just accept the credit rating given. Examining the credit rating trend of the issuer will provide additional insight.
Many municipal bonds are tax-exempt on the federal, state and local level. However, that doesn’t necessarily mean you’ll make more money from a tax-exempt muni than if you bought taxable bonds. Munis usually generate lower interest payments. So when comparing yields, be sure to do so on an after-tax basis.
You might opt to invest in munis if:
- Bonds are a part of your asset allocation plan. You’ve decided to invest a certain percentage of your portfolio in bonds.
- You need tax-free income. Municipal bonds are always tax-exempt at the federal level and often at the state or local level, too. Check with your tax advisor before making any potentially expensive assumptions.
- You’re willing to take on more risk for a higher return. Munis involve more risk than government bonds. In exchange for that bump in risk you’ll be offered a higher coupon (rate of interest) than Treasuries.
- You have an insider’s knowledge of your municipality’s prospects. Buy what you know is particularly true of municipal bonds, since they often involve investing in your hometown. Municipal bonds allow you to trade on your unique perspective and hopefully get ahead of the market curve.
Laddering is a bond strategy that spreads your risk over a series of different maturities, while maintaining an average maturity that suits your investment goal’s time horizon. Laddering doesn’t usually make sense for municipal bonds unless you’re investing $100,000 or more.
Investment Time Horizon
Your time horizon may vary according to your investment objectives, asset allocation, risk tolerance and available capital. Try to choose a bond with a maturity date that coincides with when you expect to need the money.
Some investors gradually shift from higher-risk investments like stocks to lower-risk investments like municipal bonds as the time horizon for a given financial goal approaches.
When to Get In
You might buy municipal bonds if:
- You expect interest rates to decrease in the future.
- You want to transition assets into municipals as your time horizon for reaching a financial goal approaches.
- You are super-nervous about the stock market.
- You don’t have a clear outlook on the market as a whole.
- You need tax-free income.
When to Get Out
Municipal bonds are usually purchased with the intention of holding them until maturity. That said, you might liquidate your holdings if:
- You expect interest rates to increase.
- You are concerned about the financial health of the issuer, well in advance of a negative credit rating change.
- You are comfortable with the risk-reward relationship offered by the stock market.
- You have a clearer outlook on the stock market.
- You need the money for a specific purpose.
- The bond reaches its maturity date.
Municipal bonds are usually purchased with the intention of holding them to maturity, which makes for a low-maintenance investment. However, these bonds are not without risk. You should monitor the credit rating of the issuer on an ongoing basis. In addition, you may wish to follow the tax base of your GO bond, or the business performance of the enterprise backing your revenue bond, to get an insight into the issuer’s financial health and therefore credit-worthiness. If you just wait for the credit rating to be negatively affected, it will likely be too late to minimize your potential losses. Staying on top of the factors that influence credit ratings allows you to adjust your holdings accordingly, if necessary, before the crowd.
Munis may be subject to call provisions, which means the issuer may redeem the bonds early, well before maturity. In general, issuers tend to call munis when interest rates have fallen significantly and it makes financial sense to do so. If this is the environment you find yourself in, be ready to find a new investment for the principal from your called bond.
The interest payments you receive while holding municipal bonds also deserve your attention. Each individual coupon payment may not seem like much money. However, stashing these payments in a savings account over the course of a year can mount to a nice chunk of change. Possibly consider reinvesting these funds to purchase additional bonds on an annual basis.
Among the three bond types, muni bond prices are smack-dab in the middle in terms of volatility: They may fluctuate a bit, more so than Treasuries but usually less than corporates.Fluctuation in bond prices is a factor of changes in interest rates and changes in credit quality. If you hold your bonds until maturity, the volatility they experience between now and then doesn’t change the fact that you will receive the full face value at that time.
However, tolerating this volatility as it occurs may be easier said than done. Be sure to choose a municipal bond investment that is consistent with your risk tolerance. Increased time-to-maturity, higher coupons, longer duration, illiquidity and bonds trading at a discount are all additional factors which can increase the volatility of bond prices.
Ally Invest Margin Requirements
After the trade is paid for, no additional margin is required. Investment-grade municipal bonds are rarely available for margin.
Investments in municipal bonds are tax-exempt at the federal level. If you live in the geographic location where the bond is issued, most likely it will not be taxable at the state or local level. When comparing these bonds to other investments always be sure to adjust coupon rates so you are evaluating after-tax yields for both investments. Consult your tax advisor for the low-down on this important topic.
Ally Invest Tips
- Munis are particularly suited for taxable accounts due to their generally triple tax-exempt status
- Use the Rule of 100 or Rule of 120 for your asset allocation.