How to buy municipal bonds: Investing in your community
- Mar 13, 2023
- 9 min read
What we'll cover
The definition of a municipal bond or "muni"
Types of municipal bonds and tax-free considerations
Pros and cons of investing in municipal bonds
Did you know the securities in your portfolio can affect public improvement projects, such as highway repairs, school renovations, sewer system updates and more? If you invest in municipal bonds — a.k.a. "munis," you can directly invest in your community.
If this investment type piques your interest and 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) 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 lend money to state or local entities for expensive projects. Like a loan, you receive interest payments, called coupons, and the principal returns to you at the bond's maturity date.
When comparing different types of bonds, municipal bonds are considered a higher-risk investment than Treasury bonds. You might think munis are unlikely to default because governments issue them, but that's not always the case, and 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.
Credit rating agencies such as Standard & Poor's (S&P), Moody's and Fitch's rate municipal bonds to help investors assess the creditworthiness of the issuer and the likelihood of default. A higher credit rating generally indicates a lower risk of default and a lower likelihood that the issuer will be unable to make interest and principal payments.
For example, the rating scales used by Standard & Poor's include AAA (the highest rating), AA, A, BBB, BB, B, CCC, CC and C (the lowest rating).
What are the types of municipal bonds you can buy?
Municipal bonds raise money for projects that impact the public, and several entities can issue them. When researching munis, you can find the following types of municipal bonds:
General obligation bonds: States, cities or counties issue general obligation bonds, which are backed by the "full faith and credit" of the issuer. The issuer can tax residents to pay bondholders.
Revenue bonds: Revenue bonds come from revenues from a specific project or source, such as highway tolls or lease fees. Some revenue bonds are "non-recourse," which means that if the revenue stream crumples, the bondholders do not get to claim a portion of the underlying revenue source.
Tax-increment financing (TIF) bonds: These bonds finance development projects by freezing the tax base (property values) within a designated project area. Property taxes levied against the frozen tax base provide revenue to taxing authorities. Property taxes levied by the taxing authorities against the increased property values in the designated area are forwarded to the taxing authority that created the TIF to repay debt incurred to finance improvements made until the TIF ends.
Municipal bond funds: You can also consider purchasing municipal bond funds. These managed portfolios invest in a mix of municipal bonds and are managed by a professional manager.
Municipal bond exchange-traded funds (ETFs): Municipal bond ETFs can offer you another way to invest in a group of funds. They hold a basket of municipal bonds and trade on stock exchanges like individual stocks.
Are municipal bonds tax-free?
Municipal bonds usually offer tax-free opportunities at the federal level (under IRC 103). They are sometimes tax-free at the state and local level for investors residing in the state where the bond was issued. However, there are a few tax traps to know about and understand:
State income taxes: You may have to pay state income taxes, particularly if you buy municipal bonds from a state where you do not reside. The interest may be subject to state and local taxes in this case.
Alternative minimum tax: If you receive a muni from a state with high tax rates, the interest from the bond may be subject to the alternative minimum tax (AMT). The AMT is separate from the regular income tax and designed to ensure that high-income taxpayers pay a minimum tax. It has different rules and exemptions and uses a different tax formula.
Social Security income taxable amount: If you receive Social Security, your muni bond interest will count toward your adjusted gross income, possibly increasing your Social Security income taxable amount. If you receive Social Security benefits, a portion of your benefits may become taxable if your combined income, including taxable interest from municipal bonds, exceeds certain thresholds.
De minimus tax: For bonds purchased at a discount of more than 0.25% for each full year from the time of purchase to maturity, any gains that come from the discount rate get taxed as ordinary income, which generally carries a higher tax rate compared to the capital gains rate, reducing the amount you make.
In your eagerness to avoid taxes, you may choose an investment vehicle with a poor return, so consider the trade-offs before investing.
You may also run into interest rate risk or the risk that the value of an investment will decrease because of a rise in interest rates. As interest rises, the market value of outstanding bonds may fall, meaning they're less attractive to investors. The bond price can then decline, leading to a capital loss. On the other hand, if interest rates fall, the market value of bonds can increase and leave you with a capital gain.
How will munis affect your taxes? Consult a tax professional and understand the tax implications before investing in municipal bonds.
What is the average rate of return on a tax-free municipal bond?
The average rate of return on a municipal bond varies depending on several factors, including the issuer's credit quality, the bond's term and current market conditions. Municipal bonds generally offer lower yields compared to taxable bonds due to their tax-free status.
The average A-rated muni yields approximately 3.8%, roughly 75 basis points more than the average AAA rated-muni. One basis point equals one one-hundredth of a percentage point, or 0.01%.
How much money do you need to buy municipal bonds?
The price of a municipal bond can vary depending on a few factors:
Credit quality: The issuer's credit quality makes a difference in the cost of the municipal bond.
Bond term: A municipal bond term refers to the length of time until the bond reaches its maturity date. The issuer must repay the face value of the bond to you, the bondholder, upon the maturity date. The term can range from a few months (short-term bonds) to 30 years or more (long-term bonds).
Coupon rate: The coupon rate refers to the annual interest rate the bond pays its bondholders. It is expressed as a percentage of the bond's face value and usually paid semi-annually. The coupon rate is determined when the bond is issued and remains fixed for the bond's life. The coupon rate affects the bond's yield, which is the return that the bond generates for the bondholder. A higher coupon rate will typically result in a higher yield, and a lower coupon rate will typically result in a lower yield.
Market conditions: Market conditions refer to the state of an economy or industry. They can affect the underlying interest rate of a particular bond.
Most municipal bonds occur in a minimum denomination of $5,000. To target institutional investors, municipal bonds sometimes come in larger amounts, such as $25,000 or $100,000. Municipal bonds also may be issued in a minimum denomination of $1,000 to attract local investors.
What are the benefits of investing in muncipal bonds?
If bonds are part of your asset allocation plan, consider munis whether you're building a fixed-income portfolio or balancing your equity holdings.
Adding munis to your portfolio has the bonus of potentially investing in projects that could benefit communities. Whether you replace education facilities in your hometown or refurbish 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.
Tax exemptions: Earnings on municipal bonds are tax-exempt at the federal level and are often exempt at state or local levels. 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 way to generate tax-free income.
Interest payments: Investing in munis instead of other types of bonds could also be beneficial because they could offer higher returns. On the risk and reward scale, munis typically, but not always, fall between Treasury bonds and corporate bonds. 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.
Minimal default risk: The average five-year municipal default rate since 2012 is 0.1%. Municipal issuers are, on average, rated much higher than corporate bonds.
What are the drawbacks of muncipal bonds?
You can hold municipal bonds until maturity, making for a low-maintenance investment. But these bonds are not without risk.
Low credit ratings: Check the issuer's financial health and creditworthiness. That way, you have a better chance of minimizing potential losses should the bond issuer's credit rating be negatively affected. Staying on top of the factors that influence credit ratings allows you to adjust your holdings accordingly.
Call provisions: Issuers 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, consider a new investment for the principal from your called bond.
Tax-exemptions may not offer benefits: Tax exemptions sound 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? Munis usually generate lower interest payments. When comparing bond yields, it's a good idea to do so on an after-tax basis.
Price volatility: Tolerating price volatility as it occurs may be easier said than done. Be sure to choose a municipal bond investment consistent with your risk tolerance. Increased time-to-maturity, higher coupons, longer duration, illiquidity and bonds trading at a discount can increase the volatility of bond prices.
How can I buy municipal bonds?
Whether you invest in munis as part of a socially responsible investing (SRI) strategy or to balance out your portfolio, you can buy municipal bonds on the primary or secondary market. But where to buy municipal bonds? However, it's typically less common to invest in the primary market. You'll likely buy municipal bonds from a bond dealer, broker or bank like Ally Invest.
If you want to avoid investing directly in the bond market, you can also invest in bonds through mutual funds or ETFs (exchange-traded funds). Both of these invest in several underlying holdings.
When you invest in a bond mutual fund or bond ETF, your portfolio has exposure to all the individual bonds 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 offer a more accessible way to invest in bonds than investing directly in the bond market. Remember that because mutual funds and some ETFs are actively managed, these investments typically come with associated fees.
When you're ready to invest in municipal bonds, consider your investment time horizon (the amount of time you have to invest), your investment objectives, asset allocation, risk tolerance and available capital. Choose a bond with a maturity date that coincides with when you expect to need the money.
Selling municipal bonds
Most investors purchase municipal bonds to hold them until maturity. That said, liquidating your holdings before then might happen.
You might consider selling your bond if you expect interest rates to increase. 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%, it will increase in value and will usually trade higher than its face value. That's known as a premium. But suppose the prevailing interest rate rises above 5%. In that case, 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 before a negative credit rating change if you are concerned about the issuer's financial health. Or if you need the money for a specific purpose, selling your bond ahead of its maturity could make sense. Finally, if your desired asset allocation has changed, you might sell your munis and invest in securities with more significant potential for growth.
Supporting community improvement with municipal bonds
One of the benefits of investing is having the opportunity to put your money toward organizations, entities or causes you support. Investing in munis allows you to 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.
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