Did you know public improvement projects like highway repairs, school renovations, sewer system updates, and more can all be affected by the securities in your portfolio? That is, if you invest in municipal bonds — a.k.a. “munis.” If this type of investment piques your interest, but you’re wondering how to buy municipal bonds, read on.
What are municipal bonds?
Municipal bonds are debt securities issued by states, cities, counties, and other government entities (other than the federal government) in order to raise money for public improvements for all types of things — from hospitals to bridges to water treatment plants. When you invest in munis, you basically lend money to state or local entities to use it toward expensive projects. Like a loan, you receive interest payments, called coupons, and the principal is returned to you at the bond’s maturity date.
When comparing different types of bonds, municipal bonds as a whole are typically considered to be a higher-risk investment than Treasury bonds. While you might think munis are unlikely to default, because they’re issued by governments, that’s not always the case — some municipalities have defaulted on their obligations in the past. It’s important to understand these investments are not risk-free, and you should always review the bond’s rating before investing.
Pro tip: Higher coupon rates tend to signify a lousy rating, meaning higher risk of default.
What kind of municipal bonds can you buy?
Municipal bonds are used to raise money for all sorts of projects that can impact the public, and they can be issued by several different entities. When researching munis, you will see two varieties that are differentiated by the issuers: general obligation bonds (GO for short) and revenue bonds. GO bonds are backed by the issuer’s ability to collect taxes, like a state government. Revenue bonds are issued by entities like water companies or sewage treatment plants that, like the name implies, generate revenue over time. These entities then use the income they generate to make interest payments, as well as repay the loan in its entirety on the maturity date.
A double-barreled credit is a municipal bond that blends these two types. Both kinds of municipal bonds typically pay periodic interest every six months, or twice per year until the bond matures.
You might think GO bonds are less risky than revenue bonds because they’re backed by the issuer’s unlimited taxing authority. But this assumption isn’t necessarily true. Why? Taxing authority is limited by real-world political and economic factors — and many utilities operate like well-run businesses, raising rates when costs are expected to increase. Because of this, it’s important to examine bonds beyond just whether they’re GO or revenue.
One way to do so is to by analyzing the bond’s credit rating. 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.
What are the benefits of investing in munis?
If bonds are a part of your asset allocation plan, whether you’re building a fixed-income portfolio or balancing your equity holdings, you might consider munis.
Plus, adding munis to your portfolio has the bonus of potentially investing in projects that could benefit communities. Whether it’s refurbished education facilities in your hometown or a new water system that could improve the livelihood of folks in a state 1,000 miles away, revenue generated from the sale of munis can help fund essential projects that impact lives around the country. If you take an ESG (environmental, social, corporate governance) approach to picking out the securities you invest in, you may find munis allow you an opportunity to invest in the bond market while having an impact on communities.
Earnings on municipal bonds are always tax exempt at the federal level — and they’re often exempt at state or local levels as well. Of course, it’s critical to check with your tax advisor to understand the tax consequences of any investment. But investing in munis could be a smart way to generate some tax-free income.
Even if your primary goal for investing in munis isn’t generating income, you can still take advantage of your interest payments. Each individual coupon payment may not seem like much money — but stashing these payments in your Online Savings Account can amount to significant savings over time. Or you could consider reinvesting these funds by purchasing additional bonds on an annual basis.
Investing in munis instead of other types of bonds could also be beneficial because they may offer higher returns. On the scale of risk and reward, munis typically, but not always, fall between Treasury bonds and corporate bonds.
Munis, like Treasurys and corporates, may also experience price volatility. Bond prices fluctuate based on changes in interest rates and the credit quality of the issuer. But, if you hold your bond until maturity, you’ll receive the full face value that you paid for it — even if the bond experiences volatility in the meantime.
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.
What are the drawbacks of municipal bonds?
Municipal bonds are usually intended to be held to maturity, which makes for a pretty low-maintenance investment. But these bonds are not without risk. You should monitor the credit rating of the issuer on an ongoing basis.
You might also wish to follow governmental entities that collect the taxes to support the GO bonds you purchase, or the performance of the enterprise backing your revenue bond, to get insight into the issuer’s financial health and credit-worthiness. That way you have a better chance minimizing potential losses should the credit rating of the bond issuer be negatively affected. Staying on top of the factors that influence credit ratings allows you to adjust your holdings accordingly, if necessary.
Another risk to be aware of is that many munis carry call provisions, which means the issuer may redeem the bonds early, even well before maturity. In general, issuers tend to call, or redeem, munis when interest rates have fallen significantly and it makes financial sense for them to do so. If you find yourself in this situation, you may consider a new investment for the principal from your called bond.
As previously mentioned, earnings on many municipal bonds are tax-exempt on the federal, state, and local level. That sounds like a good thing, but it doesn’t necessarily mean you’ll make more money from a tax-exempt muni than if you bought taxable bonds. Why? Because munis usually generate lower interest payments. So, when comparing bond yields, it’s a good idea to do so on an after-tax basis.
How can I buy municipal bonds?
Whether you invest in munis as part of a socially responsible investing (SRI) strategy or simply to balance out your portfolio, you can buy municipal bonds on the primary or secondary market — though it’s typically less common to invest in the primary market. In general, you’ll likely buy municipal bonds from a bond dealer, bank, or broker, like Ally Invest.
If you don’t want to invest directly in the bond market, you can also invest in bonds through mutual funds or ETFs (exchange-traded funds). Both of these are basket-like investments that invest in a number of underlying holdings.
When you invest in a bond mutual fund or bond ETF, your portfolio has exposure to all of the individual bonds that are held within the fund. Both bond mutual funds and ETFs can provide diversification to your bond allocation. Because bond ETFs trade on an exchange, like stocks, they might also provide a more accessible way to invest in bonds than investing directly in the bond market. Keep in mind, because mutual funds and some ETFs are actively managed, these investments typically have associated fees.
When you’re ready to invest in municipal bonds, you should consider your 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.
If munis don’t fit your strategy right now, you might gradually rebalance your holdings towards fixed-Income Investments (e.g. municipal bonds) as you near the time horizon for a given financial goal, like putting a down payment on a house or retirement.
Selling municipal bonds?
When it comes to municipal bonds, most investors purchase them with the intention of holding them until maturity. That said, it’s certainly not unheard of to liquidate your holdings before then.
If you expect interest rates to increase, you might consider selling your bond. That’s because bond prices move inversely to prevailing interest rates.
For example, if a bond pays a 5% coupon and the prevailing interest rate drops below 5%, that bond pays comparatively better than the alternatives — so it will increase in value and will usually trade higher than its face value. That’s known as a premium. But if the prevailing interest rate rises above 5%, the bond will pay comparatively worse than the alternatives, so its value will decrease and it will usually trade lower than its face value, or at a discount.
You might also consider selling your bond well in advance of a negative credit rating change if you are concerned about the financial health of the issuer. Or, if you need the money for a specific purpose, selling your bond ahead of its maturity could make sense for you. And finally, if your desired asset allocation has changed, you might sell your munis for and invest in securities with greater potential for growth.
One of the benefits of investing is having the opportunity to put your money toward organizations, entities, or causes that you support. By investing in municipal bonds, you can even invest in public improvements in your state or even more locally. Whether you’re a fixed-income investor or just getting a feel for the bonds market, munis present a mid-level risk investment that can be an asset to any investor’s portfolio.