The greatest advantage of municipal bonds can be summed up in two words: tax free. The interest rates on municipal bonds may seem low compared to similar long-term securities like Treasury bills and CDs, but tax advantages may level the playing field. Let's look at some examples.
If you're in the 25 percent bracket for 2008 federal income taxes, you'd have to find a taxable security with an interest rate of 4 percent to equal the yield of a tax-free municipal bond with an interest rate of 3 percent [source: David Lerner]. In other words, if you have $5,000 to invest in a bond, you'd earn the same with a 3-percent tax-free bond as a 4-percent taxable bond.
The difference between taxable and tax-free bonds becomes even more exaggerated as you climb to higher income tax brackets. If you find yourself in the 35 percent federal income tax bracket, you'd have to find a 4.62 percent taxable interest rate to yield the same amount as a humble 3 percent municipal bond [source: David Lerner]. Some taxpayers also have to pay state and local income taxes, depending on where they reside. In this case, a triple tax-free municipal bond -- exempt from federal, state and local taxes -- is highly attractive.
The second major advantage of municipal bonds is that they're incredibly safe. Between 1970 and 2000, the 10-year cumulative default rate for municipal bonds was 0.04 percent [source: Fahim]. In other words, during those 30 years, less than half of one percent of municipal bonds failed to pay back the promised interest and principle. Compare that to corporate bonds -- bonds issued by private companies and investment firms to finance business operations -- which carried a default rate of 9.83 percent over that same period [source: Fahim]. Insured municipal bonds are practically risk-free, since the insurance company will pay up even if the bond issuer defaults.
You can find a tax-free bond that fits your investment strategy. Put bonds allow you to cash in earlier than the maturity rate with no penalties. Floating-rate municipal bonds allow riskier investors to adjust for fluctuating markets, and zero coupon bonds are ideal for risk-free long-term investments.
Since municipal bonds pay interest twice a year, they can also supply a predictable, tax-free income stream for retirees. Even if you sell a municipal bond before its maturity date, you'll receive the current market price of the bond -- which may be more or less than the original price -- without any additional penalties.
The only real disadvantage of municipal bonds is that they carry relatively low interest rates compared to other types of securities. This is particularly true when the economy is strong and interest rates for Treasury bills and CDs rise. Even after adjusting for taxes, it's often hard for municipal bonds to keep up with the competition. But in economic downturns, all bond rates are low, so the tax-free status makes a bigger difference.
Another less common complaint about municipal bonds is that they can be difficult to cash in if the issuer is a smaller municipality like a rural county government.
Let's learn how to buy municipal bonds and how much room they should take up in an investment portfolio.
FAQs
By purchasing municipal bonds, you are in effect lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or “principal.” A municipal bond's maturity date (the date when the issuer of the bond repays the principal) may be ...
What is the downside of municipal bonds? ›
Municipal bonds, like all bonds, pose interest rate risk. The longer the term of the bond, the greater the risk. If interest rates rise during the term of your bond, you're losing out on a better rate. This will also cause the bond you are holding to decline in value.
Do municipal bonds pay monthly? ›
Generally fixed rate municipal bonds pay interest on a semiannual basis such as on June 30 and December 31 of each year. However, municipal bonds can have different payment periods and dates, such as an annual payment.
Are municipal bonds still a good investment? ›
Still, some leading investment managers and analysts suggest it's time for investors to come back home to municipal bonds. "After two tumultuous years, we expect a municipal market recovery in 2024," says Robert DiMella, executive managing director, co-head of MacKay Municipal Managers.
Can you cash out municipal bonds? ›
Most municipal bonds have a call provision entitling the issuer to redeem the bond at a specified price on a date prior to maturity. This generally would occur if the current interest rates are lower than they were at the time the investor purchased the bonds (unless the investor purchased the bonds at a premium).
At what income level do municipal bonds make sense? ›
If you sit in the 35% income tax bracket and live in a state with relatively high income tax rates, then investing in municipal bonds (munis, for short) will likely be a better option than taxable bonds. Alternatively, if your income is in the 12% tax bracket, then you may want to steer clear of municipal bonds.
Are municipal bonds safe in a recession? ›
Stability in periods of crisis
In fact, compared to other bond markets, the credit-quality ratings of the municipal sector have been very stable, not only during the COVID-19 crisis but also during the Great Recession of 2008 and other previous economic downturns.
How much money do you need to invest in municipal bonds? ›
Investment minimums for municipal bonds are typically $5,000 per bond, so an investor with limited funds to invest and who is seeking exposure to a wide range of maturities, sectors and credits might consider a mutual fund or an ETF.
Can municipal bonds lose value? ›
Yes, that's right, decreases. Municipal bonds are generally valued for being exempt from federal taxation—and often from state and local taxes. So long as those taxes are significant, there's an advantage to buying munis. But when tax rates decline, so too does the value of holding municipals, along with their prices.
How long do you hold municipal bonds? ›
Short-term bonds mature in one to three years, while long-term bonds won't mature for more than a decade. Generally, the interest on municipal bonds is exempt from federal income tax. The interest may also be exempt from state and local taxes if you reside in the state where the bond is issued.
General obligation (GO) bonds are funded directly by tax revenues. They are the safest type of municipal bond, but they often have the lowest interest rates. 5. Revenue bonds obtain money from ticket sales, bills, tolls, or rents from municipal government projects.
Why not invest in municipal bonds? ›
Just as with every coin that has two sides, municipal bonds also come with a variety of risks despite their steady returns and tax advantages. There is potential for loss with municipal bonds if the issuer defaults, interest rates rise dramatically, inflation spikes or if the bond is called early.
Why are my municipal bonds losing money? ›
Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments ...
How much is a $100 savings bond worth after 30 years? ›
How to get the most value from your savings bonds
| Face Value | Purchase Amount | 30-Year Value (Purchased May 1990) |
|---|
| $50 Bond | $100 | $207.36 |
| $100 Bond | $200 | $414.72 |
| $500 Bond | $400 | $1,036.80 |
| $1,000 Bond | $800 | $2,073.60 |
Here are the best High Yield Muni funds
- VanEck Short High Yield Muni ETF.
- VanEck High Yield Muni ETF.
- SPDR® Nuveen Blmbg Hi Yld Muncpl Bd ETF.
- VanEck CEF Municipal Income ETF.
- Franklin Dynamic Municipal Bond ETF.
- First Trust Municipal High Income ETF.
- BlackRock High Yield Muni Income Bd ETF.
A municipal bond, also known as a muni, is debt security used to fund capital expenditures for a county, municipality, or state. Municipal bonds are commonly tax-free at the federal level but can be taxable at state or local income tax levels or under certain circ*mstances.
What kind of account should never hold a municipal bond? ›
Although municipal bonds may not be totally tax-free, we generally don't suggest investors hold them in tax-advantaged accounts, like IRAs, because the interest income they pay is generally exempt from federal income taxes.
Do municipal bonds lose value when interest rates rise? ›
The price and yield (the income return on an investment) of a bond generally have an inverse relationship. In other words, as the price of a bond goes down, the yield goes up and vice versa. Thus, when interest rates rise, a bond's price usually declines because an investor can earn a higher yield with another bond.
What is a municipal bond pros and cons? ›
Pros and cons of municipal bonds
| Pros | Cons |
|---|
| Tax-exempt from federal tax and possibly state and local tax | The bond price could fall |
| Low volatility | Not inflation-friendly |
| Minimal default risk | Still a chance of default |
Jul 29, 2022
