How Municipal Bonds Fit Into Your Investment Plan

How Municipal Bonds Fit Into Your Investment Plan

Municipal bonds are like the opposite of a lottery ticket: safe, secure, unexciting. Also unlike a lottery ticket, municipal bonds likely have a place in your investment portfolio. Here are some basics on municipal bonds and how to use them as part of your investment strategy.

What Are Municipal Bonds?

Municipal bonds are issued by cities, counties, states and other local government entities to raise money for either specific projects or to fund essential services.

There are two main types of municipal bonds: general obligation bonds and revenue bonds. General obligation bonds are used for projects that aren’t revenue-generating, like schools and roads, and are backed by the entity’s ability to raise money through taxes. Revenue bonds are for projects that do generate revenue but are still in the public interest. Examples might include a new port terminal, an addition to the local hospital or a new airport. These bonds are funded by the revenue the project generates.

The Advantages of Municipal Bonds

The biggest advantage associated with municipal bonds is that, in most cases, income from them is not taxed by the federal government and often isn’t taxed by state or local governments either. This advantage is particularly attractive if you’re in a high income bracket or you live in a high-tax area, and you are investing through a taxable brokerage account. When comparing municipal bonds to other investment products, it’s important to keep this tax advantage in mind.  However that tax advantage is moot if your money is already in a tax protected account such as an IRA, Roth IRA, or 401(k).

Municipal bonds are also considered a low-risk investment. They have a relatively low interest rate, but the chances that you will lose money due to a default or devaluation are low. This makes them a good option for investors who are mostly concerned with preserving their capital investment while generating a modest income stream from interest payments.

If you are investing in bonds issued by your local government you can also get the satisfaction of knowing that your investment portfolio is helping your community with concrete projects that would otherwise not be possible. Sometimes this might have other financial benefits, like increasing the value of property you own.

municipal bonds and risk

 

Municipal Bond and Risk

Even though municipal bonds are low-risk, they are not zero-risk. There is always a risk that the issuer could default or go bankrupt, as happened in a number of municipalities after the 2008 recession.

The other risks involved with municipal bonds are not that you’ll lose your money but that the bonds will be less advantageous than originally considered. Because one of the primary advantages of municipal bonds is their tax-free status, if your income goes down and your tax bracket changes, the tax advantages of municipal bonds could disappear. Municipal bonds have a fixed interest rate, and if the marketplace interest rate rises, your bond’s value relative to other investment products will fall.

Lastly, in most cases the bond issuer reserves the right to pay off the bonds early, which will reduce the number of interest payments you get. However, if this happens you’ll get all of your original investment plus a premium for early debt repayment and you can always reinvest it.

How to Buy Municipal Bonds

There are two primary strategies for investing in municipal bonds. You can either buy individual bonds, or you can invest in a mutual fund or exchange-traded fund (EFT) that invests in mutual funds.

If you buy individual bonds, you will need to either go through a broker-dealer or bank department that specializes in municipal bonds or a registered investment advisor who can buy (and sell) municipal bonds on your behalf. This strategy gives you the most control over which municipal bonds you buy. If you want to buy a bond that will finance refurbishing your local school or build a bridge near your home, you’ll want to take this route. You can also ensure that you buy bonds that maximize your tax savings by buying bonds issued in the area you live (check with your financial advisor / accountant for details on the tax implications of municipal bonds).

If your goal is simply include municipal bonds in your investment portfolio, buying a share in a mutual fund or ETF that buys municipal bonds is an easy way to do so. The ETF / mutual fund will hold thousands of individual bonds. As bonds mature the fund will reinvest the proceeds into new bonds. With this route you are buying a very small slice of all the bonds the fund holds. One advantage with a bond fund is that if a bond issuer happens to default on their payment it ends up being a very small hit relative to the entire fund.

The bottom line is that municipal bonds can be a good addition to your investment portfolio. They are low-risk, have tax advantages and help your community. That doesn’t mean there’s a magic formula for what percentage of your portfolio should be municipal bonds. It depends on your age, your investment goals and your risk tolerance. It’s also important to remember that the key to any investment portfolio is diversification. So if you invest in municipal bonds make sure to have other investments as well.

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