As an investor striving to build wealth while potentially minimizing your tax liability, municipal bonds, often called “munis,” may present a compelling investment opportunity. They are debt securities issued by state, county, and city governments. The primary advantage of investing in them lies in their potential to generate tax-free income.
Types of municipal bonds
Municipal bonds come in various forms, each with its characteristics and risk profile.
General obligation bonds (GO bonds)
General obligation bonds (GO bonds) account for 28% of the investment-grade muni market. They are typically backed by the full taxing authority of the bond issuer, such as the state or local government. This means the municipality can levy taxes on property, sales, or income to repay the bondholders if necessary.
This broad backing provides a strong foundation for repayment, generally making GO Bonds considered to have lower credit risk compared to other types of municipal bonds. Most states and local governments issue GO bonds to help fund operations or specific projects.
While the dollar value of GOs issued by states and local governments is roughly equal, there are significantly fewer states than local governments. This implies that the amount of debt issued per state is considerably larger than that issued by local government.
Revenue bonds
Revenue bonds, on the other hand, are secured by the revenue generated from specific projects, such as toll roads, airports, or hospitals. The repayment of revenue bonds relies on these projects’ successful operation and revenue generation.
For example, a toll road revenue bond’s repayment depends on the traffic volume using the toll road. If traffic volume falls short of projections, revenue may not be sufficient to cover debt service, potentially increasing the risk of default.
Consequently, revenue bonds may carry a higher risk than GO Bonds, as their repayment depends on the underlying project’s financial performance.
Advantages of investing in municipal bonds
Tax-free income. One of the most significant advantages of investing in municipal bonds is the potential for tax-free income. This can be particularly beneficial for investors in higher tax brackets. By generating tax-free income, you can boost your after-tax returns and potentially increase your overall investment gains.
Diversification. Municipal bonds can also play a valuable role in diversifying your investment portfolio. You can potentially reduce overall risk by includingthem in your portfolio. This is because their returns are typically less correlated with the stock market. When stock prices decline, their prices may not necessarily follow the same downward trend, providing some stability to your overall portfolio.
Potential for capital appreciation. While primarily known for their income potential, municipal bonds can also offer opportunities for capital appreciation. In a declining interest rate environment, the value of existing bonds with higher interest rates may increase. This can result in capital gains for investors who hold these bonds until maturity or sell them before maturity.
Disadvantages of investing in municipal bonds
Credit risk. Like any debt security, municipal bonds carry credit risk, meaning the issuer may default on their debt obligations. This risk varies depending on the financial health and creditworthiness of the issuing municipality.
To assess the creditworthiness of a municipal bond issuer, you can consider factors such as the issuer’s overall financial condition, debt levels, economic stability of the region, and overall economic outlook. Credit rating agencies, such as Moody’s, S&P Global, and Fitch Ratings, provide independent credit ratings for municipal bonds, which can serve as a valuable guide.
Liquidity risk. Some municipal bonds, particularly those issued by smaller municipalities or with unique features, may have limited liquidity. Buying or selling these bonds quickly at a fair price may be difficult. Limited liquidity can increase the risk of losses if you need to sell the bonds before maturity.
Interest rate risk. Like other fixed-income securities, municipal bonds are subject to interest rate risk. When interest rates rise, the value of existing bonds with lower interest rates typically declines. This is because investors can purchase newly issued bonds with higher interest rates, making older bonds with lower yields less attractive. Conversely, when interest rates fall, the value of existing bonds with higher interest rates generally increases.
How to make money on municipal bonds: Are they worth it?
You can potentially make money on municipal bonds in a few ways:
Interest income. The primary way to earn income from municipal bonds is through periodic interest payments. These payments are typically made semi-annually.
Capital gains. You can realize a capital gain if you sell a municipal bond before its maturity date and the market price has increased. This can occur when interest rates decline, as the value of existing bonds with higher interest rates tends to rise.
Tax-free income. As discussed earlier, the tax-free nature of municipal bond income can significantly boost your after-tax returns, especially if you are in a higher tax bracket. This tax advantage can enhance your overall investment returns.
Are municipal bonds worth it?
Whether or not municipal bonds are worth it for you depends on your individual financial situation, investment goals, and risk tolerance. Consider these factors:
- Tax bracket. If you are in a higher tax bracket, the tax-free income feature of municipal bonds can be particularly advantageous.
- Investment goals. If you seek income and diversification within your fixed-income portfolio, municipal bonds can be a valuable addition.
- Risk tolerance. Consider your risk tolerance carefully. While GO Bonds generally carry lower credit risk, Revenue Bonds can be more susceptible to credit risk depending on the underlying project.
It’s crucial to conduct thorough research and consider your financial circumstances before making investment decisions. Consulting with a qualified financial advisor can help determine if municipal bonds are suitable for your specific needs and objectives.
