Municipal bonds are popular for two reasons. First, the interest income is often free from federal, state, and local income tax, which is why municipal bonds are often advertised as "triple tax-free". Second, municipal bonds fund projects take place in our communities, often having a huge impact on our daily lives. For example, a state or local government might issue a bond to improve safety conditions on a heavily congested highway, to upgrade a sewer or water facility, or to add a new critical-care wing to a hospital. Therefore, municipal bond investing is often a win-win for the investor and the community.
Municipal bonds are an extremely safe investment, especially if you are retired and on a fixed income. Most offer a predictable semi-annual stream of income that is helpful in terms of budgeting for both day-to-day living expenses and larger expenditures. Plus, municipal bonds are sold in a wide range of options to meet the objective of just about any investor. You can choose among different issuers and between coupon and zero coupon issues. Perhaps most importantly, you can choose the quality of the investment that fits your financial goals and level of risk tolerance.
The Safety of Municipal Bonds
Just like bonds issued by the U.S. Treasury and corporations, municipal bonds are sold as short-term and long-term investments. Short-term bonds mature within one year and long-term bonds have maturity dates with more than one year. Short-term bonds are usually issued by a municipality or state in order to raise cash quickly. Long-term bonds are usually issued to finance large-scale capital projects.
General obligation bonds are backed by the full faith and credit of the issuer. They are generally supported by a municipality's or state's ability to levy taxes. It's important to note that these issuers have credit ratings just like the federal government and individuals. If you're considering a municipal bond, be sure to check the credit rating of the issuer.
Revenue bonds are backed by revenues that the issuer earns on a continuing basis. For example, states with toll roads often back bonds with income earned from drivers. Municipalities and states are also often in the business of renting land and buildings, and will back a revenue bond with rental income. When researching revenue bonds, be sure the issuer is projecting an adequate amount of revenue in order to pay the principal and interest on the outstanding bonds.
The Risks of Municipal Bonds
The risks of municipal bonds are the same as other bonds. The issuer could default, the bond could be called away, or the value of the bond could change.
The call feature isn't part of all municipal bonds, but some issuers will include a call option in order to retire outstanding debt. If interest rates have dropped, the issuer might call the bond and reissue a new bond at a lower rate. For some investors, this action not only takes away a stream of income, but may also trigger a taxable event.
Bonds can pay either a fixed amount of interest or a variable rate. A fixed rate cannot change during the life of the bond, but a variable rate will change based on interest rates. The price of the bond, however, can change based on any number of circumstances. For example, demand for the bond in the secondary market can increase or decrease based on market conditions, an increase or decrease in the issuer's credit rating, or a change in interest rates. Of these three, interest rates are almost always the reason bond prices fluctuate.
When interest rates get lower, new bonds are sold with lower yields. That makes the older bonds worth more than the new ones, which means the demand for them will increase and push prices higher. When interest rates increase, new bonds are sold with higher yields. That means older bonds are worth less than newer ones, which means demand for them will decrease and push prices lower.
Tax Considerations When Investing in Municipal Bonds
With the exception of those investors who are subject to the alternative minimum tax and must include interest earned on some types of municipal investments in order to calculate their tax due, most municipal bond holders receive interest payments that are free from federal, state, and local income tax. This is a great advantage if you're in a high tax bracket, if you live in a highly taxed state, or if the interest you would earn on the bond would place in you in a higher tax bracket.
Before jumping in to a municipal bond, however, it's important to compare the yield of a taxable investment, such as a corporate bond, to the yield of the tax-free investment. You want to make sure that the tax-free investment isn't earning less than a taxable one, even if it means paying less tax.
For example, if you are single and in the 28% tax bracket, the taxable equivalent of a 4% yield is a 3% non-taxable yield. In other words, if a tax-exempt investment earns a 3% yield, you'll need to earn 4% on a taxable investment in order for each of them to provide the same amount of income. If the taxable investment pays less than 4%, choose the tax-exempt bond. Choose the taxable investment if it pays more than 4%.
If you are married and file a joint tax return with your spouse, and if you are in the 35% tax bracket, the taxable investment will need to yield 4.62% in order equal a non-taxable investment yielding 3%.
Bonds that are sold for a gain before the maturity date can be subject to capital gains tax. In order for the lower capital gains rate to apply rather than the potentially higher ordinary income tax rate, the bond must be held for at least one year. Bonds sold at a loss before the maturity date are not subject to capital gains tax. There are also special tax rules that apply solely to the sale of municipal bonds prior to the maturity date. Always be sure to consult with a tax professional before selling a bond before it matures.
In sum, municipal bonds are a great way to earn income and potentially increase the overall value of your portfolio.
While we've covered the basics of bond investing here, there is much more to maximizing the success of your bond investing strategy. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More Bond Guidance
- Bond Investment Guide — The complete guide to bond investing.
- US Treasuries — Details about how to invest in US treasuires.
- Corporate Bonds — Details about how to invest in corporate bonds.
- Bond Rates — Factors affecting bond rates, and how to find the best ones.
- Bond FAQ — Frequently asked questions about bond investing.