Interest rate risk: Similar to other fixed-income counterparts, muni bonds generally have an inverse relationship with interest rates. So if interest rates go up, bond prices come down, and vice versa. If you purchase a bond and later interest rates rise, you are locked into receiving a return less than what you would receive by buying a new bond at the higher interest rate.
Thus, the price or market value of your bond falls as your bond is worth less. Call risk: Some muni bonds are callable, which means the issuer can decide to repay the bond earlier than the maturity date. When interest rates fall, an issuer with the ability to call their bond may choose to do so because the issuer can save money by refinancing or reissuing another bond at a lower interest rate. If you think they have a place in your portfolio, there are a few ways to get started.
You can buy individual muni bonds or muni funds in your online brokerage account, and many robo-advisors offer munis as part of their portfolio mix. Individual bonds: Many investors purchasing muni bonds have a buy-and-hold strategy, intending to hang on to them until maturity. These investors can research and select bonds that work best for their portfolio in terms of risk and return, maturity date and tax benefits.
Municipal bond ladders: When you purchase an individual bond and hold it, you don't get your principal back until the bond matures. Some muni bonds mature in one to three years, while others mature in 20 or 30 years. Investors needing regular income might consider buying multiple bonds and building a ladder, with bonds maturing annually or in whatever time increment that fits their situation and cash flow needs. Muni funds: For those who might not feel comfortable picking municipal bonds on their own, investing in munis through mutual funds or exchange-traded funds , also known as ETFs, can make sense.
One benefit is accessing a well-diversified portfolio of bonds from municipalities with different credit ratings, a range of projects and bond types GO or revenue , and varied risk and return. This lessens any potential default risk as you spread your dollars across many bonds. Another benefit is shifting the onus to someone else well-versed in municipal bonds, namely the fund manager, to keep tabs on the municipalities and related risks for you.
Some investment management companies offer state-specific funds so investors can benefit from both federal tax exemption as well as state and local tax exemption. How muni bonds work. Types of muni bonds. General obligation bond. Revenue bond. Learn More. Should you consider muni bonds? Benefits of muni bonds. This is why bond values are usually more stable than stocks. The value is easy to calculate: You add up the bond's face value and the interest it will pay.
The main thing that affects the value of a bond is the interest rate. A bond that pays a higher interest rate than a new issue -- meaning brand-new bonds just coming up for sale -- is worth more money, while a bond that pays a lower interest rate than a new issue is worth less money. That's because the price you could sell the bond or buy it for is adjusted up or down based on current available yields.
Municipal bonds come in two varieties: general obligation and revenue bonds. General obligation bonds are used to finance public projects that aren't linked to a particular revenue stream.
Revenue bonds, by contrast, are used to finance public projects with the potential to generate revenue. There are advantages and drawbacks to investing in each type. General obligation bonds are used to fund public projects, such as building a park or improving a school system, that don't inherently make money but better the communities they serve. General obligation bonds are backed by the full faith and credit of the issuer, meaning they're not secured by any specific asset bondholders can repossess.
As such, general obligation bonds have been one of the safest kinds of bonds you could buy. Revenue bonds are issued by municipalities to finance revenue-generating projects like a toll road or concert hall. The cash generated by the project itself will pay back investors in those bonds. Revenue bonds have higher default rates than general obligation bonds since the funds are used for a specific project, which may or may not be completed on time and within budget and may not generate the projected revenues.
So it's important to research the issuer's credit rating before risking your capital. New issues are bonds that a municipality sets up for a new project. The secondary market is where you can buy bonds that are already issued from other investors or sell not-yet-matured bonds you already hold.
Bond funds are investments in a fund that owns bonds. You own a stake in the bonds via your ownership of that fund.
In all of these cases, you'll buy and sell through a broker, similar to how you invest in stocks. It's important to understand the fees you'll pay, as well as the potential "markup" -- a selling price above face value -- of the bond.
Brokers who buy and sell municipal bonds are required to register with the Municipal Securities Rulemaking Board MSRB , which governs the muni bond market. They're required to disclose certain pricing information so that you, as an investor, can understand what you're paying. A mutual fund or exchange-traded fund ETF that invests in bonds might be appropriate as well.
Your investment in a muni bond fund gives you a small stake in every municipal bond the fund owns. The benefit is instant diversification , which can help you avoid losses from being too exposed to a single bond. The downside is potentially high recurring fund management fees. On the whole, municipal bonds have a low default rate. That is, the interest payments are not taxed at the federal level.
Some states do not tax municipal bonds, but others do. It is, not surprisingly, complicated. Seven states have no income tax at all, so bond interest is a moot point. Other states don't tax in-state bonds but do tax out-of-state bonds in some circumstances. There are a number of reasons to look carefully at municipal bonds before taking the plunge, and to compare them against other choices for investing your money:.
Use the tax-equivalent-yield formula to compare the real return on a muni bond with a corporate bond. Translation: That's the yield that the muni must have in addition to its federal tax-free status to be equal to the yield of a corporate bond. Bonds used to fund local and state government projects like buildings and highways are afforded tax-exempt status at the federal level. Plus, people who purchase bonds issued by their states or localities may not be required to pay state or local taxes on the interest.
That means some municipal issues have triple tax-free status. These tax advantages are offset by lower interest yields. Municipal bonds typically have lower coupon rates than similarly rated corporate issues with comparable maturities.
So, when considering munis, investors should compare the yields of taxable investment-grade and government bonds by using the tax-equivalent-yield formula. Tax-equivalent yield TEY is the yield that a taxable bond must have to equal or exceed the tax-adjusted yield of a municipal bond. In general, higher-income investors with theoretically higher tax bills are likely to benefit more from municipal bonds than individuals in other tax brackets.
The risks of default by governments that issue muni bonds in the U. However, bonds by definition have interest rate risk, which is important to investors who want to sell their bonds on the secondary market. When interest rates fall, a long-term investor may even face risk to their principal investment. A bondholder selling a year issue may receive less in principal than the bond initially cost.
Over the past decade, annual inflation in the United States has ranged between Otherwise, it was 2. This means that a year municipal bond that yields 2. Purchasing-power risk is the biggest potential drawback to investing money long-term in bonds.
You'll get your money back in the end, but it may be worth less to you than it was. Investing solely in low-yielding municipal bonds is a safe approach but it could well mean giving up returns that exceed the rate of inflation and protect your purchasing power. A balance between municipal bonds and relatively riskier stocks can offset that risk. Between and , 0. That's why muni bonds are considered a relatively safe investment. The acid test of muni bond resiliency came with the COVID pandemic as business activity ground to a halt and taxable receipts halted with it.
Total defaults rose year-over-year to just 0. A bond that is issued with a callable option adds another risk to the investor. It means that the issuer can cancel the issue, pay off the principal and stop the interest payments.
The issuer wants that option, in case interest rates drop substantially, giving it the opportunity to issue a new bond at a lower interest rate. Most municipal bonds are callable. Their investors will get their money back, but they'll have to find a new way to invest that money. A new investment in bonds will earn them less. The alternative minimum tax can be a tax trap for muni bond investors who have very high income from tax-shielded sources. As noted above, tax-free muni bonds are not always entirely tax-free.
Bonds are particularly attractive to senior citizens seeking a steady stream of income for their retirement needs. That makes Social Security income the most common pitfall for muni bond investors. Although the bonds are income-tax-free at the federal level, the income from muni bonds is counted towards the investor's adjusted gross income.
A higher adjusted gross income can raise the portion of the taxpayer's Social Security income that is taxable. High-income individuals also can run into the alternative minimum tax, which is aimed squarely at taxpayers with substantial income from tax-shielded sources.
An investor can buy and sell bonds directly through an online brokerage account. They also can be purchased through a full-service brokerage or a bank. Another option is to invest in an exchange-traded fund ETF or mutual fund that invests in muncipal bonds. Here are the answers to some commonly asked questions about municipal bonds.
In late , interest rates were rising, and municipal bond rates were rising along with them. As of Oct. A year AAA-rated bond returned 1.
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