Your Complete Guide to Municipal Bonds

What are municipal bonds?

Municipal bonds are debt securities issued by states, cities, counties, and other government entities (other than the federal government) in order to raise money for public improvements for all types of things — from hospitals to bridges to water treatment plants. When you invest in munis, you basically lend money to state or local entities to use it toward expensive projects. Like a loan, you receive interest payments, called coupons, and the principal is returned to you at the bond’s maturity date.

When comparing different types of bonds, municipal bonds as a whole are typically considered to be a higher-risk investment than Treasury bonds. While you might think munis are unlikely to default, because they’re issued by governments, that’s not always the case — some municipalities have defaulted on their obligations in the past. It’s important to understand these investments are not risk-free, and you should always review the bond’s rating before investing.

Pro tip: Higher coupon rates tend to signify a lousy rating, meaning higher risk of default.

Reason #3 to like munis: Low default risks

According to Moody’s Investor Service’s annual U.S. Municipal Bond Defaults and Recoveries snapshot, from 1970-2020 the default rate – when a bond fails to make interest or principal payments – remains “rare” overall for municipal bonds, at 0.08% over the course of the study. Even during the Covid pandemic up through 2020, according to investment firm VanEck, there were only two municipal bond defaults, and neither were virus related.

Muni bonds are by no means risk-free, but the low risk of default is comforting for my conservative clients.

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Default Risk

Between 1970 and 2018, 0.16% of all municipal securities rated by Moody’s Investor Service defaulted on their payments to investors. That’s why muni bonds are considered a relatively safe investment.

The acid test of muni bond resiliency came with the COVID-19 pandemic as business activity ground to a halt and taxable receipts halted with it. Total defaults rose year-over-year to just 0.05% of the $3.9 trillion of municipal bonds outstanding.

How are municipal bonds taxed?

Municipal bonds may be completely tax-exempt, but it depends on your state and local tax law. Qualified municipal bond income and capital gains are always tax-free at the federal level, and many jurisdictions make them tax-free at local levels, as well.

Types of municipal bonds

Municipal bonds come in two varieties: general obligation and revenue bonds. General obligation bonds are used to finance public projects that aren’t linked to a particular revenue stream. Revenue bonds, by contrast, are used to finance public projects with the potential to generate revenue. There are advantages and drawbacks to investing in each type.

General obligation bonds

General obligation bonds are used to fund public projects, such as building a park or improving a school system — things that don’t inherently make money but better the communities they serve. General obligation bonds are backed by the full faith and credit of the issuer, meaning they’re not secured by any specific asset that bondholders could repossess. As such, general obligation bonds have traditionally been one of the safest kinds of bonds you can buy.

Revenue bonds

Revenue bonds are issued by municipalities to finance revenue-generating projects like a toll road or concert hall. The cash generated by the project will pay back investors in those bonds. Revenue bonds have higher default rates than general obligation bonds since the funds are used for a specific project that may or may not be completed on time and within budget and may not generate the projected revenues. So it’s important to research the issuer’s credit rating before risking your capital.

Tax-Free Municipal Bond FAQs

Here are the answers to some commonly asked questions about municipal bonds.

What Is the Average Rate of Return on a Tax-Free Municipal Bond?

In late 2021, interest rates were rising, and municipal bond rates were rising along with them.

As of Oct. 24, 2021, ten-year AAA-rated muni bonds returned 1.15% compared to 0.95% a week earlier. A 20-year AAA-rated bond returned 1.50% compared to 1.35% the week before. A 30-year AAA-rated bond returned 1.70% compared to 1.55% the week before.

Can You Lose Money on Municipal Bonds?

You can lose the money you invest in municipal bonds if the issuer defaults. That risk is vanishingly small, considering that defaults on municipal bonds reached 0.05% of $3.9 trillion of outstanding debt in 2020, a time during which local tax revenues were decimated by the COVID-19 pandemic.

You also could lose money on muni bonds if you are forced to sell the bonds on the secondary market at the wrong time. The price you get will be determined by the total dollar amount of the remaining interest payments due, factoring in the prevailing rates available on new issues.

Which States and Cities Have the Best Municipal Bonds?

The best muni bonds from any issuer are rated AAA. They are issued by state and local governments nationwide and their bonds have been deemed AAA by one of the major rating agencies.

When a government runs into economic trouble, its bond ratings suffer (but it also will pay a better interest rate in order to attract buyers).

After its 2013 bankruptcy, the city of Detroit missed payments on three of its general obligation bonds. That means it was responsible for three out of seven defaults on muni bonds rated by Moody's Investors in that year.

The city has since managed to work its way back from a "negative" outlook to a "stable" outlook from S&P Global as of January 2021. Its outstanding debt was rated BB-.

A bond rated AAA or close to it is one of the best municipal bonds. A bond issued by a local government that is teetering on the brink of bankruptcy is one of the worst.

Investors who don't care to keep an eye on the finances of state and local governments they invest in can invest in a bond mutual fund or ETF. It will be managed by someone who gets paid to pay attention to these things.

Are Municipal Bonds Safe?

A municipal bond, or any bond for that matter, is safe as long as its issuer does not financially collapse. Luckily, that's highly unlikely in the U.S. bond market.

The bond investor's best protection is to take care:

  • Check the bond rating. Defaults are rare, but they happen. A rating of AAA, AA, or A indicates an issuer that is on a sound financial footing.
  • Compare the real return on the municipal bond to other options for your money. It's always nice to save money on taxes but not at the cost of a better return for a comparable risk elsewhere, such as in high-quality corporate bonds.

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Benefits and Risks

Benefits and Risks

Corporate Bonds benefits and risks Benefits Risks Potential for higher returns – Corporate bonds can offer higher yields than those offered by other fixed income securities with similar maturities, but with more risks.  Liquidity – Many corporate bonds are actively traded in the secondary market Tooltip , which allows access to principal prior to maturity.  Diversification – Corporate bond prices generally behave differently from stocks, so they can offer diversification benefits to a portfolio. The wide selection of corporate bonds also makes it possible to diversify by issuer, industry, maturity, credit ratings Tooltip , and interest payment schedule. Credit quality – Corporate bonds generally have lower credit ratings—and higher credit risk—than those of U.S. government bonds. If the issuing company is financially unable to make interest and principal payments, the investor’s investment may be at risk. Subordinated vs. unsubordinated bonds – Bonds from a single issuer are ranked in order of priority of payment in the event of a bankruptcy. Senior debt, which is paid first, may have a higher credit rating and higher credit quality than junior, or subordinated, debt.  Secured vs. unsecured bonds – Corporate bonds can be secured or unsecured obligations of the issuing company. Secured bonds generally have lower credit risk and lower coupon payments compared to unsecured bonds issued by the same corporate issuer. 

Should you invest in municipal bonds?

The answer to this question depends on your financial goals and situation. Just as with other bonds, the biggest reason to own them is lower risk of losing capital, in exchange for lower potential total returns. This is particularly important with funds in which you want the lowest level of risk of permanent losses, or as part of a diversified portfolio of stocks and bonds.  

When considering muni bonds, especially if you’re comparing one or more to corporate bonds, don’t forget to factor in the other benefits, like historically lower risk of losses and potential tax benefits that result in higher after-tax yield. 

How to Invest in Municipal Bonds

There are several ways that investors can invest in municipal bonds, either directly or through the purchase of bond funds.

Here's a look at the most common and effective ways to invest in municipal bonds:

In General

Investors can purchase bonds directly through traditional Wall Street sources like banks, investment brokerage companies, bond dealers, and even directly from the municipality that issues the bonds.

On Primary Bond Markets 

Investors can also purchase new municipal bonds on the primary market, although it's a market usually reserved for high net-worth investors. You will need an account at a credited bond seller (like an investment bank that underwrote the bond issue, and you'd have to work directly with a representative from the appropriate bank you're registered at to square away the exact investment you want to make in the municipal bond issue (i.e., the bond coupon, maturity date and amount of bonds you want to buy.)

There is no pricing markup to buy municipal bonds on the primary market.

On the Secondary Market 

The secondary market is where most Main Street investors purchase municipal bonds, usually at a $1,000 face value per bond (although the secondary market values the bond issue in $100 pricing increments.)

Here, the municipal bond has already been issued, so you have a wider choice of places to purchase the bonds, including banks, brokerage houses, bond dealers, and in the open market from other municipal bond investors.

The secondary market does make it easier to purchase municipal bonds directly, but expect to pay a moderate markup or commission to close the deal.

Via Mutual Funds or Exchange-Traded Funds

Municipal bond mutual fund and exchange-traded fund offerings make it easy to invest in a group of municipal bond issues in one fund, and at a lower price of entry compared to individual municipal bonds.

Buying municipal bonds via mutual funds also provides access to professional fund managers who choose what municipal bonds to include in the fund and which ones to sell. You can easily invest in a municipal bond mutual fund directly by opening an account with a fund company that sells municipal bonds funds, or through online means via a discount brokerage firm.

Note that you will have to pay a small investment fee, starting at about 0.15% of your total investment, although some high-end mutual funds charge a 1% fee, for presumably higher-scale investment expertise.

Common questions

How do bond yields work?

The yield you’re quoted when you buy a bond is often different from the interest it pays. Why? Because in addition to the annual interest rate, the bond’s return reflects any difference between its purchase price and its face value—the amount you’re expected to receive when the bond matures.  

If you buy the bond at a price higher than the face value (at a premium), you’ll receive less than you paid when the bond matures.  

If you buy the bond at a price lower than the face value (at a discount), you’ll receive more than you paid when the bond matures.  

If you sell the bond before it matures, you get its current price, which may be higher or lower than the amount you originally paid.

Who issues bonds?

Bonds are issued by both public and private entities. Cities, states, the federal government, government agencies, and corporations issue bonds to raise capital for a variety of purposes, such as building roads, improving schools, opening new factories, and buying the latest technology.

What determines a bond’s yield?

Two key factors that determine a bond’s yield are credit risk and the time to maturity.  

Credit risk: A bond’s yield generally reflects the risk that the issuer will not make full and timely interest or principal payments. Rating agencies provide opinions on this risk in the form of a credit rating. Bonds with lower (higher) credit ratings generally pay higher (lower) yields because investors expect extra compensation for greater risk.  

Maturity: Generally, the longer the maturity, the higher the yield. Investors expect to earn more on long-term investments because their money is committed for a longer period of time.

Selling municipal bonds?

When it comes to municipal bonds, most investors purchase them with the intention of holding them until maturity. That said, it’s certainly not unheard of to liquidate your holdings before then.

If you expect interest rates to increase, you might consider selling your bond. That’s because bond prices move inversely to prevailing interest rates.

For example, if a bond pays a 5% coupon and the prevailing interest rate drops below 5%, that bond pays comparatively better than the alternatives — so it will increase in value and will usually trade higher than its face value. That’s known as a premium. But if the prevailing interest rate rises above 5%, the bond will pay comparatively worse than the alternatives, so its value will decrease and it will usually trade lower than its face value, or at a discount.

You might also consider selling your bond well in advance of a negative credit rating change if you are concerned about the financial health of the issuer. Or, if you need the money for a specific purpose, selling your bond ahead of its maturity could make sense for you. And finally, if your desired asset allocation has changed, you might sell your munis for and invest in securities with greater potential for growth.

One of the benefits of investing is having the opportunity to put your money toward organizations, entities, or causes that you support. By investing in municipal bonds, you can even invest in public improvements in your state or even more locally. Whether you’re a fixed-income investor or just getting a feel for the bonds market, munis present a mid-level risk investment that can be an asset to any investor’s portfolio.

Invest in communities and diversify your portfolio by buying municipal bonds through Ally Invest.

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