What Is A Municipal Bond And How To Buy This Kind Of Security
Municipal bonds, also called "munis," are debt securities that entities issue to fund capital projects. What Is A Municipal Bond?
"Municipal bonds (or munis, for short) are debt securities issued by states, cities, counties and other governmental entities to fund day-to-day obligations and to finance capital projects, such as building schools, highways or sewer systems," according to the Securities and Exchange Commission .
Munis are exempt from federal taxes and sometimes state taxes and "are a relatively safe investment," Jason Fannon, CFP, senior partner of Cornerstone Financial Services in Southfield, Michigan, told me. However, he added that an investor needs to assess a muni before investing in it. "Municipal bonds have different credit qualities based upon the underlying health of the municipality [or other government entity]. An investor should either hire a manager or perform their own due diligence into the credit quality of the municipal bond."
How Do Municipal Bonds Work?When you buy a municipal bond, you are lending money to the bond issuer, be it a city, a school district or a transportation authority, in exchange for the promise to you of regular interest payments, usually issued semi-annually, and the return of the original investment or principal.
Although a muni's maturity date, which is when the bond issuer repays the principal, could be more than a decade off, short-term bonds come due in one to three years.
Much more than breaking news, our diverse reporting digs deeper with unparalleled insights that empower you to make better informed decisions. Become a Forbes member and unlock unlimited access to cutting-edge strategies, actionable insights, and updated analysis from our network of leading finance experts.
Types of Municipal BondsMunicipal bonds come in three varieties–general obligation, revenue and conduit–whose differences I explain below.
General Obligation BondsStates, cities or counties issue general obligation bonds. Although assets don't secure these bonds, they "have the backing of the 'full faith and credit,' of the issuer, which has the power to tax residents to pay bondholders," according to the SEC.
"Talking about safety, from the three types of munis (general obligation, revenue and conduit bonds), general obligation bonds provide the most safety, as they are secured by tax-paying power of the issuer," Arham Ulla, CPA and principal at Tangent Consulting Services, based in Mississauga, Ontario, told me.
Revenue BondsRevenue bonds are more risky than general obligation ones because they are backed by a specific project or source, which could be highway tolls or lease fees.
"Some revenue bonds are 'non-recourse,' meaning that if the revenue stream dries up, the bondholders do not have a claim on the underlying revenue source", noted the SEC. In other words, you as the bondholder don't get paid.
Conduit BondsConduit bonds are issued through "third-party entities that act on behalf of the actual borrowers, typically private nonprofit (501(c)(3)) entities," according to the financial services company Fidelity Investments .
In the best-case scenario, conduit borrowers agree to repay the issuer, who pays the interest and principal on the conduit bonds, and you reap a return on your investment. However, holders of conduit bonds, which are issued on behalf of private entities, such as nonprofit colleges and hospitals, could be left without a return, if the conduit borrower fails to make a payment. This means that the issuer usually is under no obligation to pay you the bondholder.
Why Invest in Municipal Bonds?Munis are considered a safe investment, in which you pay no federal taxes and sometimes no state taxes, and they provide you with a steady income stream and have a relatively low rate of default. According to the Municipal Securities Rulemaking Board , referencing data from Moody's Investor Service, there was a 0.09% default rate on investment-grade munis compared with 2.25% investment-grade corporate bonds, between 1970 and 2022.
Finally, "when the Fed [Federal Reserve] lowers rates, it leads to higher prices on bonds, and therefore positive total returns for munis," wrote Charles Schwab. "While each rate-cutting cycle over the past three-plus decades has been unique, munis have delivered positive 12-month total returns in five of the last seven rate-cutting cycles."
Tax Benefits Of Municipal BondsAll munis are exempt from federal taxes, and even state taxes in some cases. If the issuer is based in the state of your residence, you are exempt from state tax also.
Even though corporate bonds may pay more than munis, if you are in a high tax bracket, you may realize a higher return owning munis because of their federal-tax exempt status, according to the financial services company Charles Schwab . "Consider a municipal bond that yields 3.3% compared to a fully taxable corporate bond that yields 4.7%. For bondholders in the 32% and above tax brackets, a muni may yield more after considering the impact of federal, state and other taxes," wrote Charles Schwab.
Risks Of Investing In Municipal BondsNo investment is risk-free, including munis. "[A muni's] values will go up and down depending upon the market, just like any bond investment,".Larry Pon, CPA, and owner of Pon & Associates, in Redwood City, California, told me.
"Municipal bonds are generally safe, but there is some variance. For example, a small municipality with a large amount of debt is less safe than a well-capitalized state like Wyoming. In general, they are approximately about as safe as corporate bonds, but not as safe as U.S. Government Debt," Robert Persichitte, CPA and CFP and an affiliate professor at Metropolitan State University of Denver , told me.
Discover more in-depth insights, entrepreneurial advice and winning strategies that can propel your journey forward and save you from making costly mistakes. Elevate your journey by becoming a Forbes member. Unlock unlimited access to premium journalism plus exclusive members-only events gathering leading business minds that shape tomorrow.
How To Evaluate A Municipal BondTo look before you leap into a muni investment, conduct your own due diligence first by checking its credit rating, yield and maturity date.
A credit rating can show an entity's financial strength of companies and government entities, especially their ability to meet principal and interest payments on their debts, according to the Corporate Finance Institute . "The rating assigned to a given debt shows an agency's level of confidence that the borrower will honor its debt obligations as agreed," wrote CFI
Credit RatingThe U.S. credit ratings agencies Standard & Poor's Global Ratings, informally known as S&P, Moody's and Fitch Group, which determine the creditworthiness of a bond, stock or commodity, control 95% of ratings business, according to CFI.
Each agency uses a unique system of letters to indicate creditworthiness. The highest S&P rating is AAA and the lowest, D, for Moody's, the ratings go from Aaa to C and for Fitch, its ratings are from AAA to D.
Many ways exist to evaluate yields, which is the annual return an investor receives on a bond, based on the purchase price of the bond, its coupon rate and the length of time the investment is held. Other yield measurements, noted Charles Schwab , are yield to maturity, yield to call, yield to worst and current yield.
Larry Pon cautions investors about yield to call bonds."Watch out for bonds with call features because they will look very attractive when you purchase them, but the call feature will allow the issuer to pay off the bond earlier than maturity," he told me. "This means you will get less interest, and not that very attractive interest rate you would have gotten for the longer period of time."
Maturity is the date the principal of a municipal security is payable to you as a bondholder, unless the bond is redeemed prior to maturity (see yield to call, above). Munis' maturities range between one to 30 years. Your own cash flow, income and other investments can help you determine the optimal maturity date for each muni you invest in.
How To Buy Municipal BondsInvestors can buy municipal bonds through banks, brokers and bond dealers, using brokerage services, investment advisory services or separately managed accounts (SMAs), through a secondary market or through their own efforts.
When you use a brokerage firm to buy a muni, a financial professional accepts the order to buy, sell and hold a specific muni investment and may also agree to monitor the investment. They charge mark-up or mark-down and transaction-based fees and also a sales charge for buying and selling it if it is part of a mutual fund or ETF.
If you have a separately managed account SMA, a professional money manager will execute the trade for you and charge an asset-based fee,
You can also buy bonds yourself, but most financial professionals don't recommend taking that route because it can be complicated and expensive to do so. Pon said the minimum investment can be very high for an individual investor.
Determining If Municipal Bonds are Right For YouHow do you decide if investing in munis is right for you?
You do so the way you do on any purchase or investment–by answering these questions:
Most financial professionals said that investing in munis now is a good idea, especially if you're in a high income bracket.
"We're in a favorable environment for municipal bonds," Doug Kuring, CFP, with the Wealth Enhancement Group headquartered in Plymouth, Minnesota, told me. "Many municipalities are in good financial shape, and as the Federal Reserve begins to lower interest rates, investors will likely shift out of short-term Treasuries and into varying types of bonds with longer maturities to lock in yields."
He added that munis' yields on an after-tax basis look better than those on taxable bonds, and that once the Tax Cuts and Jobs Act sunsets at the end of 2025, "tax-exempt income from munis becomes even more appealing.".
Bottom LineWhy not buy municipal bonds? They are exempt from federal taxes and sometimes state taxes, too, and they have a low chance of default. However, do your homework first before sinking funds into one. Munis do go up and down, like any investment. Only you can decide if they are right for you.
Read Next
