Municipal Bonds: what they are, how they work, and how to buy them

Municipal bonds are issued by states, cities, or other local governments to raise money to fund services or infrastructure projects (road repair, sewers, purchasing land, etc.).

Now that we’ve covered savings bonds, let’s get on with municipal bonds. If you aren’t already invested in municipal bonds, you should probably be making space in your portfolio for them. Like right away. Because they are awesome. Not only are they a good way to diversify, but municipal bonds are also a great way to receive income free from federal, state and local taxes. Ah, but you ask, “What the heck is a municipal bond?”

What is a municipal bond?

Cutely known as “munis,” these bonds are issued by states, cities, or other local governments to raise money to fund services or infrastructure projects (road and bridge repair, sewers, purchasing open land, etc.). The primary advantages to investors are security and tax benefits. For example, most municipal bonds offer interest earnings that are exempt from federal taxes.

In addition, if you are a resident of the state in which you own one or more municipal bonds issued by local governments, your earnings may also be exempt from state or local taxes. Never assume a high security factor, however. Some local governments may be in dire financial condition and your risk factor may outweigh any tax benefits you enjoy.

How do municipal bonds work?

There are two types of munis; general obligation (GO) and revenue municipal bonds. General obligation bonds are guaranteed by the issuing municipality’s ability to tax its constituents. From tiny towns in the middle of nowheresville, USA to the biggest, most populous states, general obligation bonds run the whole gamut.

These types of municipal bonds are often issued to pay for public works like schools or sewer systems. As a general rule, GO munis are considered to be safer than revenue munis.

General Obligation Munis

Going even further, there are actually two subcategories of GO bonds. There are Unlimited Tax General Obligation Bonds, and Limited Tax General Obligation Bonds.

Unlimited Tax GO bonds are guaranteed, i.e. they will pay out based on the power of their taxable base. It can use property taxes, sales taxes, etc. to repay the bonds.

Limited Tax GO bonds are slightly different. These have a more narrow taxing power. You might have a limited tax general obligation bond that is issued to build a new hospital in a tiny county. The people in that county might then agree to a 1% increase in the medical services tax for the next three years in order to pay off the debt. Thus you can see how the source of where the money is coming from – the taxable base – is much narrower than with an unlimited tax general obligation bond.

Revenue Municipal Bonds

Revenue municipal bonds, on the other hand, are issued by special state or local government entities, such as a utility company or a public transportation authority. They have to be issued by government agencies or funds that act like a business (i.e.: they have expenses and operating revenues). These bonds are unique in that the revenue generated by the specific project in question will be used to pay off bondholders.

So for example, if revenue bonds are being issued to finance the building of a YMCA or local gym, then the bondholders are paid back from all the revenue earned from gym member subscriptions. If revenue munis finance the construction of a toll bridge then the tolls earned from that bridge will pay back the bondholders.

Why should I buy municipal bonds?

Now you understand what municipal bonds are, here are the three main reasons why you want to buy them:

1) Munis give you tax-free income.

A major benefit of muni bond interest: it is free from federal taxes! Additionally, if you purchase a tax-exempt bond from the state you live in, then your investment is free from state taxes as well. When you earn interest from your savings account or dividend portfolio, that money is taxed as income. However, when you earn interest on a tax-free muni, you get to keep that sweet, sweet cash all to yourself. Ah…

2) They have relatively low risk.

Ok, so there’s no such thing as a free lunch. We all know that, and while no investment can be totally free from risk, municipal bonds are historically known to be less risky than stocks or corporate bonds. They have a lower default rate than corporate bonds, meaning you have a better chance of getting your money on-time and in full.

Astonishingly, since 1970 – a full 45 years – there has not been a single default on AAA-rated municipal bonds. In that same time period, only 0.01% of municipal bonds rated Aa (the second highest rating) have defaulted. In comparison their corporate bond counterparts have defaulted at a rate of 0.49% and 0.99% for AAA and Aa ratings respectively.

3) They are great for diversification.

Diversification is good for a portfolio because it makes it more robust to shocks. The key to diversification is making sure not all your investments move together. If stocks go down, you want something else in your portfolio to be increasing in value so to as to mitigate the loss in equity. To that end, high-yield municipal bonds have historically had very low correlation to other asset classes. They behave differently to equities and government bonds making them very useful diversifiers.

To buy municipal bonds:

Municipal bonds can be purchased through an investment broker. Some brokers actually specialize in bonds, but any stockbroker can make the purchase for you. Transaction fees for buying a municipal bond through a broker are typically between 0.5% to 3% of the purchasing price. The minimum price for a municipal bond is almost always $5,000 and goes up in increments of $5,000.

There are two primary ways to start investing in municipal bonds. One is to purchase individual municipal bonds directly and the second is to buy a mutual fund that invests in municipal bonds.

1. Individual Municipal Bonds

Individual municipal bonds can be bought through bond dealers, banks, brokerage firms and in a few cases directly from the municipality.

2. Municipal Bond Mutual Fund

Municipal bond funds offer professional management of a bond portfolio. This way, a manager would select and buy bonds for the mutual fund. As an investor, you’d simply buy shares in the municipal bond mutual fund through either a traditional or online brokerage firm or directly from a mutual fund company.

So municipal bonds are tax-exempt, excellent diversifiers for any portfolio and are relatively risk-free. Just to sweeten the pot, municipal bonds also have yields that are attractive relative to other fixed-income alternatives. The yield on the Barclays High-Yield Muni Index is actually higher than the yield on the Barclays U.S. Corporate High Yield Index.

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