Municipal bonds: Investing pros and cons

Furthermore, buying individual muni bonds can be quite expensive. You can purchase them from discount brokers, but the trading commission is baked into the price rather than charged separately. So you really don't know what you're paying in commissions. And brokers aren't eager to provide bargains, especially to investors buying bonds in small denominations.

Dixon views $25,000 as the minimum size that makes sense if you want to buy individual municipal bonds. And he says you'd want at least 20 different issues to gain adequate diversity. That amounts to a minimum of $500,000 in total. His firm calls three different bond brokers when making a purchase to ensure it receives a fair price.

ETFs or mutual funds?

For those choosing muni bond funds, Dixon recommends ETFs over mutual funds. "Expenses are lower for ETFs, and they are more transparent. With mutual funds, holdings information is updated just once a quarter," says Dixon of Carl Domino Inc. Most ETFs are based on an index, so their holdings don't change much.

The average expense rate for a muni ETF is 0.27 percent, compared to 0.98 percent for an open-end muni mutual fund, Morningstar says.

But Sjoblom says mutual funds carry some advantages over ETFs. While ETFs are based on an index, mutual fund managers can choose their holdings as they see fit. And while some mutual funds are risker than ETFs, ETFs can have credit issues, too.

Moreover, "where liquidity is not that high, inefficiencies can be in favor of the active manager versus the indexer," Sjoblom says. "There have been sizable differences between the value of ETFs and their underlying indices."

In choosing a muni bond mutual fund, you want to start with ones that have a history of success. Sjoblom advises looking at how a fund has performed in periods of distress, such as 2008. And she recommends looking for funds with below-average expenses, as there are plenty of good ones available.

Experts caution against jumping into muni bonds at this point. The market has been hot in recent months, with the Barclays Capital Municipal Bond Index producing a total return of 12 percent over the last year. At some point, there will be a correction.

"Munis have been on such a tear, there's definitely a risk of losses in the short run if yields rise, which they eventually will," Sjoblom says. "I'm not good at timing the market, but this certainly isn't a great time to make a huge move into it."


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