Did you know the investment securities in your portfolio can affect public improvement projects, such as highway repairs, school renovations, sewer system updates and more? Investing in municipal bonds — aka "munis” — is one way you can invest in your community.
Read more: Which investment accounts are right for you?
What are municipal bonds?
Municipal bonds are securities issued by government entities other than the federal government (think states, towns, municipalities, etc.) to raise money for public improvements. When you invest in munis, you’re lending money to fund expensive projects. Like a loan, you receive interest payments, called coupons, and the principal is returned to you when the bond matures (aka reaches the end of its designated sentence).
Credit rating agencies such as Standard & Poor's (S&P), Moody's and Fitch's rate municipal bonds to help investors assess the creditworthiness of an issuer. While not a guarantee, a higher credit rating generally indicates a lower risk of default and a lower likelihood that the issuer will be unable to make interest and principal payments.
When you invest in munis, you're lending money to fund expensive projects.
What are the types of municipal bonds you can buy?
When researching munis, you might find the following types of municipal bonds:
General obligation bonds: Backed by the "full faith and credit" of the issuer, which can tax residents to pay bondholders
Revenue bonds: Come from specific projects or sources, such as highway tolls or lease fees. Some are "non-recourse," which means that if the revenue stream crumples, the bondholders don’t get to claim a portion of the underlying revenue source.
Tax-increment financing (TIF) bonds: Primarily used to finance development project and are typically paid back using the property taxes levied against the development area
Municipal bond funds: Managed portfolios invested in a mix of municipal bonds and are managed by a professional manager
Municipal bond exchange-traded funds ( ETFs): Hold a basket of municipal bonds and trade on stock exchanges like individual stocks
Are municipal bonds tax-free?
There are a few investment tax concepts to know about and understand when it comes to municipal bonds. Consider consulting a tax professional, if you're wondering how municipal funds might affect your taxes.
State income tax: You may have to pay state income taxes if you buy municipal bonds from a state where you do not reside.
Alternative minimum tax (AMT): Interest from the bond may be subject to the AMT depending on the amount.
Social Security income tax: Muni bond interest will count toward your adjusted gross income, possibly increasing your Social Security income taxable amount.
De minimus tax: Gains from bonds purchased at a discount may be taxed as ordinary income.
What are the benefits of investing in municipal bonds?
Here are a few benefits to consider:
Tax exemptions: Earnings on municipal bonds are tax-exempt at the federal level and often at state or local levels.
Interest payments: Munis could offer higher returns compared to other types of bonds.
Community benefit: Adding munis to your portfolio has the bonus of investing in projects that could potentially benefit communities.
What are the drawbacks of municipal bonds?
You can hold municipal bonds until maturity, making for a low-maintenance investment. But these bonds are not without risk.
Low credit ratings: Check the issuer's financial health and creditworthiness.
Call provisions: Issuers may redeem the bonds early, even before maturity.
Lower interest: Munis usually generate lower interest payments.
Inflation: Rising inflation could mean you lose investment value due to the fixed-rate nature of munis.
Buying municipal bonds directly
Typically, there are two ways you can buy municipal bonds, both through a brokerage or advisor:
Primary market purchases: Buying directly from the issuer (a local government, for instance)
Secondary market purchases: Buying from another investor (think of it as buying a pre-owned item versus a brand-new one)
Steps to buy directly
Once you've done your thorough due diligence (as you should do for any potential investment), here is one method of purchasing municipal bonds to consider:
First, you'll need a brokerage account, if you don't already have one.
Research available municipal bonds using tools provided by your broker.
Consider the credit rating and interest rates offered by different bonds.
Consider the maturity date to decide if it coincides when you expect to need the money.
Once you're ready, you can place an order through your broker for the desired bond.
If you want to avoid investing directly in the bond market, you can also invest in bonds through mutual funds or ETFs. Both of these invest in several underlying holdings.
Whether you're a fixed-income investor or just getting a feel for the bonds market, munis present a mid-level risk investment that have potential to be an asset to any investor's portfolio.
