What Are Municipal Bonds? A Beginner’s Guide to Investing

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Municipal bonds are debt securities issued by state and local governments to fund public projects like schools, highways, and utilities. Investors buy these bonds in exchange for regular interest payments and the return of their principal at maturity. The biggest advantage? Many muni bonds are tax-free, making them an attractive option for conservative investors.

In this guide, we’ll break down how municipal bonds work, the different types, their benefits and risks and how you can invest in them.

How Do Municipal Bonds Work?

When a city, state or local government needs funding for a public project, it can issue municipal bonds to raise money. Investors purchase these bonds, essentially lending money to the government in exchange for interest payments (known as coupon payments).

Interest payments are usually made at regular intervals and the full amount of the bond (called the principal), is repaid on the bond’s maturity date. Bond ratings are important because they show how likely a municipality is to repay the loan; higher ratings mean lower risk for investors. Traditionally, these types of bonds are tax-exempt. However, there are some instances where you may have to pay taxes.

Example: If you invest $10,000 in a municipal bond with a 3% interest rate, you’ll receive $300 per year in interest payments until the bond matures.

Key Features of Municipal Bonds

• Issued by state and local governments – Unlike corporate bonds, munis help fund public infrastructure.
• Fixed or variable interest rates – Most muni bonds pay semi-annual interest to investors.
• Maturity periods vary – Bonds can range from short-term (1-5 years) to long-term (20-30 years).
• Many are tax-free – Interest is often exempt from federal taxes and sometimes state and local taxes.

If you live in the same state where the municipal bond is issued, you may avoid state and local taxes on your interest income.

On the other hand, buyers in the secondary market may find opportunities to purchase bonds at a discount, allowing them to earn higher yields than originally offered. Trading municipal bonds in the secondary market adds flexibility and liquidity, enabling investors to adapt their strategies to changing market conditions.

Types of Municipal Bonds

There are two primary types of municipal bonds:

General Obligation Bonds (GO Bonds)

General Obligation Bonds, or GO Bonds, are backed by the credit and taxing power of the government entity that issues them, making them a more secure investment. These bonds are ideal for conservative investors because they carry relatively low risk.

• Backed by the full credit and taxing power of the government
• Used to fund public services like schools, roads and emergency services
• Considered low-risk since they are supported by taxpayer money

Example: A city issues a GO bond to finance the construction of a new public high school. The city repays bondholders using local property taxes.

Revenue Bonds

Revenue bonds are secured by specific revenue sources, like tolls, utility payments or taxes collected from particular projects. Unlike General Obligation Bonds, these bonds are backed by the income generated by the project they are used to fund.

• Backed by revenue from specific projects (e.g., toll roads, hospitals, airports)
• Higher risk than GO bonds since repayment depends on project earnings
• Higher potential returns than general obligation bonds

Example: A state issues a toll road bond, and the bondholders are repaid using toll fees collected from drivers.

Comparing General Obligation Bonds vs. Revenue Bonds

If you’re a conservative investor, GO bonds are typically the safer option, while revenue bonds offer higher returns with slightly more risk.

Benefits of Investing in Municipal Bonds

Municipal bonds offer several advantages for investors, especially those looking for stable, low-risk returns.

• Tax-Free Interest: Most municipal bonds are exempt from federal income tax and some may also be state- and local-tax-free.
• Low Risk: Because they are backed by government entities, muni bonds have a lower default rate than corporate bonds.
• Steady Income: Investors receive predictable interest payments, making them great for retirement income.
• Diversification: Adding municipal bonds to your portfolio reduces overall risk, especially in times of stock market volatility.

High-income earners benefit the most from tax-free interest, as municipal bonds help reduce taxable income.

Risks of Investing in Municipal Bonds

While municipal bonds are safer than corporate bonds, they still come with some risks:

• Credit Risk: While rare, a local government could default on its bond payments.
• Interest Rate Risk: If interest rates rise, the market value of your bond may decrease.
• Inflation Risk: Since muni bonds offer fixed interest payments, inflation could reduce their real purchasing power.
• Market Risk: If you need to sell before maturity, the bond’s price may fluctuate based on market conditions.

Check the bond rating before investing. AAA-rated bonds are the safest, while lower-rated bonds offer higher yields but come with more risk.

How to Buy Municipal Bonds

Municipal bonds can be purchased through various channels:

1. Directly From the Government

• TreasuryDirect.gov offers municipal bonds from state and local governments.

2. Brokerage Firms

• Buy new or secondary market muni bonds through Fidelity, Vanguard or Charles Schwab.
• Typically requires a minimum investment of $1,000 to $5,000.

3. Municipal Bond Funds & ETFs

• Invest in a diversified portfolio of muni bonds through mutual funds or exchange-traded funds (ETFs).
• Best for investors looking for liquidity and diversification.

If you prefer less hands-on management, a municipal bond ETF may be best.

Tax Considerations with Municipal Bonds

Municipal bonds can be desirable investments due to federal tax exemptions on the interest earned, benefiting individuals in higher tax brackets. Additionally, some states offer tax exemptions on municipal bond interest if the bonds are issued within the investor’s home state.

• Federal Tax Exemption: Most municipal bond interest is exempt from federal income tax.
• State & Local Tax Exemptions: If you buy bonds issued by your home state, you may not owe state taxes.
• Capital Gains Tax: If you sell your bond before maturity at a profit, you may owe capital gains tax.

If you’re in a high tax bracket, investing in tax-free municipal bonds can help reduce your taxable income. The tax-exempt status does not extend to any capital gains from selling the bonds, which are typically taxable. Proper reporting ensures compliance with tax laws and helps avoid penalties.

However, interest earned from municipal bonds issued outside of the investor’s state may still be subject to state income tax. Investors need to understand that even though the interest may be tax-exempt, it still needs to be reported on federal and state tax returns.

Are Municipal Bonds Right for You?

Municipal bonds are an excellent choice for conservative investors looking for steady, tax-free income. Municipal bonds provide tax-exempt interest, making them a smart option for investors in higher tax brackets seeking stable income with lower risk than stocks. While they offer advantages, potential downsides include state taxes on out-of-state bonds and the risk of losing money if sold before maturity. Considering factors like credit rating, the issuer’s financial health, and investment timeline helps you determine if this investment class is for you.

If you’re considering municipal bonds, explore options with your financial advisor or check bond ratings to find the safest investments.

Editorial Note: This content is not provided by any entity covered in this article. Any opinions, analyses, reviews, ratings or recommendations expressed in this article are those of the author alone and have not been reviewed, approved or otherwise endorsed by any entity named in this article.

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