Investing fundamentals: What to know about municipal bonds

You already may know that bonds are the yang to the stock market’s yin. While stocks generally provide a greater potential return at a higher risk, bonds are considered relatively safe, offering a steady but modest source of income. Owning a strategic mix of the two asset classes is a classic way to build a diversified, risk-adjusted portfolio. Beyond that basic refresher, however, there’s much more to learn about bonds, including an often-overlooked subset of the market—municipal bonds—which can offer meaningful tax advantages for certain investors.

In this article, we’ll cover the fundamentals of municipal bonds: how they work, how they differ from other types of bonds and whether they might be a good fit for your portfolio.

What are municipal bonds?
Municipal bonds—munis for short—are debt instruments issued by state or local governments. They’re used to fund major public projects like building or improving schools, parks, libraries, stadiums, roads and bridges, or utilities like power plants and water treatment facilities.

“Whether they’re issued by a state agency or a school district in a small town, muni bonds all have one thing in common—they fund things that make communities better,” said Leslie Martin, a fixed income portfolio manager with Cavanal Hill Investment Management Inc., a subsidiary of BOKF, NA.

How do they work?
As with other types of bonds, a muni enables an investor to loan money to the issuer for a set period of time. The issuer promises to pay you back the principal (called the “face value”) when the bond matures, which could be any duration from a year to 20 years or more. More importantly, the bond carries a fixed interest rate (the “coupon rate”) which generates an annual return (the “yield”) as long as you own the bond.

There are two main types of munis: general obligation (GO) bonds and revenue bonds. With GO bonds, the issuer makes interest payments with money it takes in from property taxes. Revenue bonds, on the other hand, are paid for using a specific revenue stream, such as residents’ utility fees or toll road collections.

Why do people invest in munis?
The short answer is “tax-free income,” said Martin.

“The most attractive benefit of munis is that the interest earned is (with some exceptions) exempt from federal income tax. Also, if you buy bonds issued in your home state, the interest is free from state income taxes and, in some cases, local taxes as well,” she said.

That is the key difference between munis and other types of bonds such as Treasuries (federal government-issued bonds) or corporate bonds, for which the income is subject to taxes.

“Some people also just feel good about investing in the betterment of their local area,” said Shane Delavan, private wealth market manager at BOK Financial®. “It may be secondary and intangible, but there can be a psychological benefit to supporting your community financially.”

Who should consider munis?
“Generally, investors in higher federal tax brackets get the biggest advantage from munis,” said Delavan. “This is because, while other types of bonds may offer higher yields, the significant tax savings from munis ultimately results in a higher after-tax return.”

Affluent investors in states with high income taxes—such as California, Hawaii, New York and New Jersey—can realize an even higher total return by investing in locally issued bonds.

Conversely, Delavan explained, munis aren’t typically as attractive for people in lower tax brackets, because the tax savings aren’t large enough to beat what they could earn from taxable Treasuries or corporate bonds.

However, “Munis can still be useful for average investors looking to mitigate risk in their portfolio,” said Martin. “Particularly, longer-term munis that offer higher yields relative to Treasuries may be more suitable and worthwhile for people in mid-tier tax brackets.”

What are the risks involved?
“On the risk spectrum, munis generally fall somewhere in between Treasuries (very low risk) and corporate bonds (somewhat riskier),” said Martin.

There are several types of risk to consider, the first of which is default risk. While defaults can happen, they are very rare for munis. That’s because if a local government has trouble meeting its debt obligations, it can simply raise taxes and fees to cover the shortfall.

“A more likely scenario is when a bond issuer shows signs of distress, it may be downgraded by credit ratings agencies. The Fed also could raise interest rates, allowing new bonds to offer higher yields,” said Martin. “In either case, the bond you own would lose value on the secondary market, and you could lose money if you needed to sell the bond before its maturity date.”

How can I invest in munis?
Individual muni bonds can be purchased directly through a securities broker, but due to high investment minimums, this is typically more advisable for high-net-worth investors who can commit substantial capital. The simplest route for most investors is to buy into a mutual fund or exchange-traded fund (ETF) that owns a diversified portfolio of bonds.

“As with any investment, it’s always a good idea to start with advice from an experienced professional who understands the market,” said Delavan. “Your CPA can also help you get a clear picture of whether munis will help you from a tax perspective.”