Essential Guide to Successfully Invest in Municipal Bonds 2021
What are Municipal Bonds?
Municipal bonds are bonds issued by states, cities, counties and other government entities. The bonds are used to fund day to day operations or capital projects such as roads, schools, airports and more. The current Municipal bond market is 3.7 trillion.
Benefits of Municipal Bonds
- Tax-free interest, which makes them an attractive investment option for individuals in high tax brackets. Municipal bonds are exempt from federal taxes and generally exempt from state taxes if the issuer and investor are in the same state.
- Low default rates, the Municipal default rate is 0.08%compared to a default rate on corporate bonds of 2.5% per year
They are free of federal tax. So your interest won’t be taxed as ordinary income. This is a huge benefit for individuals in high tax brackets.
Types of Municipal Bonds
- General Obligation bonds are Municipal bonds that are not backed by assets but by the state or local governments ability to use tax revenue to pay investors.
- Revenue Bonds are Municipal bonds that use the revenue generated from the projects or another source to pay back the bonds. These bonds are not backed by the government’s ability to tax residents.
What are the risks in Buying Municipal Bonds?
Interest Rate Risk
When investing in bonds – remember the cardinal rule: The price of a bond falls when interest rates rise and when interest rates fall the price of a bond rises. Interest rate risk is the risk of the value of the bond rising or falling due to changes in the interest rates. Interest rate risk, which is sometimes referred to as market risk, increases the longer you hold a bond.
Low Default Risk
Credit risk or sometimes referred to as default risk— is the risk that interest and/or principal payments on the bond will not be paid on time and in full. Over the last 10 years only 0.8% of municipal bonds rated investment-grade defaulted. Although default risk is low, it is still possible for Municipal bonds to default.
Call risk is the potential for an issuer to repay the bond before its maturity date. This is something the issuer may do if the interest rates decline. Most municipal bonds are callable. Before you invest in the bonds you should check their provisions.
Inflation is the rise in prices over time. Inflation reduces the purchase power of the dollar over time, which is a risk to investors that are holding municipal bonds receiving a fixed rate of interest. To reduce inflation, sometimes the Federal Reserve raises interest rates, which in turn, will lead to a lower market value for existing bonds.
Liquidity risk is that for a certain amount of time the investor may not be able to find an active market for the municipal bond. This can affect the price that you buy or sell the bond. Most investors purchase municipal bonds and hold them rather than selling the bonds.
Where to buy Municipal Bonds?
Ways to Purchase Municipal Bonds
- Municipal bond mutual fund
- Municipal bond exchange-traded fund (ETF)
- Trade online through a self-managed account
Mutual Funds and ETFs
Although municipal bonds are an attractive investment to individuals in higher tax brackets, they do carry a degree of risk. General obligation bonds are considered a safer investment than revenue bonds because of the government’s power of taxation. Since general obligation bonds carry less risk for an investor, the interest rate paid on general obligation bonds is less than what is paid on revenue bonds.
Revenue bonds have a higher risk of default over time, but revenue bonds also provide a higher rate of return for that risk. Investing in municipal bond mutual funds or municipal bond etfs will allow the user to invest in revenue bonds and general obligation bonds with the potential for tax-exempt earnings.
Brokerages that offer Municipal Bonds: