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Investing in municipal (muni) bonds is a way to earn mostly tax-free income from interest paid by state and local governments. These governments issue debt to fund public projects and routine expenses—things like schools, highways, hospitals, airports, and sewer systems. When you buy a muni bond, you are lending money to the issuer and, in return, receive regular interest payments and the return of your principal at maturity.
Municipal bonds typically pay fixed interest, usually in semiannual installments. Maturities can range from short-term (1–3 years) to long-term (a decade or more). Many munis are investment-grade and backed by state or local governments, so they’re often seen as lower-risk options for income-oriented investors seeking to reduce federal—and often state—income taxes.
Before investing, it helps to compare a muni’s tax-exempt yield with the yield from a taxable bond. A tax-equivalent yield calculation shows whether a muni or a taxable corporate bond will give you the better after-tax return.
How munis work
The issuer sells bonds to raise funds. As a bondholder, you receive regular interest until the bond matures, at which point you get your principal back. If you sell the bond before maturity, its market price may be higher or lower than what you paid, depending on current interest rates and other market conditions.
Example: Buying a $10,000 muni with a 4% annual coupon and a 20-year maturity means you lend $10,000 for 20 years and receive $400 a year (typically $200 every six months). If interest rates rise after you buy the bond, the bond’s market value will usually fall; if rates fall, its value will typically rise. If you plan to hold to maturity, interim price changes don’t affect the principal returned at maturity unless the issuer defaults.
Risks and tax considerations
The main risks are interest-rate risk and, rarely, credit/default risk. Rising interest rates lower bond prices, which matters most if you sell before maturity or own bond funds. Some muni interest may be subject to the alternative minimum tax (AMT), so consult a tax professional if you might be affected.
Types of municipal bonds
– General obligation (GO) bonds: Backed by the issuer’s taxing power and general revenues. Repayment relies on the issuer’s overall ability to collect taxes and fund obligations.
– Revenue bonds: Repaid from the specific revenue stream generated by the project they finance—such as tolls from a highway or fees from a water system.
How munis compare with other bonds
– Corporate bonds are issued by companies, their interest is taxable, and they typically offer higher yields to compensate for greater credit risk.
– Treasury (federal) bonds are issued by the U.S. government; their interest is taxable at the federal level but often exempt from state and local taxes. Treasuries carry the lowest default risk because they are backed by the federal government.
Tax-free munis
Tax-free municipal bonds generally provide interest exempt from federal taxes and, in many cases, state and local taxes for residents of the issuing state. Because most tax-exempt munis are investment-grade, they tend to have lower default risk and lower yields than lower-rated bonds. Yields vary with market rates, term length, and the issuer’s credit rating.
Pros and cons
Pros:
– Tax-exempt interest can be valuable for investors in higher tax brackets.
– Many munis are high-quality, with low historical default rates.
– They provide steady income and can add diversification to a portfolio.
Cons:
– Lower yields and total-return potential than many stocks and some corporate bonds.
– Vulnerable to inflation—fixed payments may lose purchasing power over time.
– Interest-rate increases can reduce market value, especially for bond funds.
– Some munis may be subject to AMT, and rare defaults are possible.
Portfolio role and allocation
Municipal bonds are generally suitable for the fixed-income portion of a diversified portfolio, especially in taxable accounts. A conservative allocation might include a meaningful share of munis if tax-exempt income benefits you, but most investors should keep some exposure to equities for growth. A 100% muni portfolio is usually appropriate only if your sole goal is capital preservation and you don’t need growth.
How to invest
You can invest in individual municipal bonds or through mutual funds and ETFs that hold many munis. Individual bonds let you hold to maturity and avoid interim price risk, while funds offer diversification and professional management. Municipal bonds are available through online brokers, banks, and many robo-advisors.
Account placement and timing
Don’t buy tax-exempt municipal bonds inside tax-deferred retirement accounts (like IRAs or 401(k)s), since those accounts already offer tax benefits. Munis tend to be most attractive to investors in higher tax brackets; after periods of very low rates, rising yields can make munis more appealing. Consider bond funds as long-term holdings and diversify across maturities to manage interest-rate risk.
Bottom line
Municipal bonds can be a smart choice for investors seeking tax-exempt income, low default risk, and portfolio diversification—especially if you are in a higher tax bracket. They’re usually best held in taxable accounts as part of a diversified allocation that includes some equities for growth.
