What are municipal bonds?

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Municipal bonds represent an attractive investment for individuals, especially for people in high income brackets, looking for assets that provide tax-advantaged income.

What makes these types of bonds worth owning is that the interest they pay out to investors is not subject to federal taxes (in some cases city and state taxes are also exempt) which makes their returns more attractive.

Whether muni bonds make sense for you depends on your income, investment goals and risk appetite.

Here’s the good and bad when it comes to municipal bonds.

What are municipal bonds?

Municipal bonds are securities issued by local governments, such as a city, state, county or municipality. When you buy a municipal, or “muni” bond, you’ll get an interest payout about twice a year and then get your principal, or initial investment, paid back to you on the bond’s maturity date.

A city might use the funds to finance things like building a new bridge or highway. Muni bonds typically range from one to 10 years, depending on if they’re short- or long-term.

Interest payments from muni bonds aren’t subject to federal taxes. And If the bonds are issued by the state or city in which the investor resides, they’re also free of state and local taxes.

“For clients in high tax brackets, munis can be superior to other fixed-income options,” says Tim Ghriskey, chief investment strategist at Inverness Counsel in New York City. But, of course, they’re not risk-free. “Certain municipal bonds carry risk. You have to do your homework. There are definitely states where bonds carry more risk.”

Pros and cons of municipal bonds

Pros Cons
Tax-exempt from federal and possibly state and local income tax. If interest rates rise, market prices of existing bonds will go down.
Low volatility; safe investment. Don’t hold up against inflation as well as stocks.
Low default risk. Still a chance of default. Ex: Detroit.

While municipal bonds are generally sound investments for people looking to keep their taxes down and risks low, they might not be right for every type of investor.

While the credit rating on the average muni bond tends to be higher than bonds issued by corporations, according to research from discount brokerage Charles Schwab, you can’t rule out a default entirely.

“Default rates tend to be low, which has remained the case, even in a tough environment, despite some predictions to the contrary,” says Miriam Sjoblom, director of fixed income ratings at Morningstar, a research firm in Chicago.

Still, the fact that there haven’t been many defaults “isn’t to say there may not be more,” says Michael Sheldon, chief market strategist at RDM Financial Group in Westport, Connecticut. “That’s something any investor has to be aware of.”

Bond breakdown: Individual, mutual or ETF?

Individual bonds vs. funds

One of the first questions for investors in munis is whether to buy individual bonds, mutual funds or exchange-traded funds (ETFs). The advantage of buying individual bonds is that you’ll get all your money back at maturity, assuming the issuer doesn’t default. By contrast, with mutual funds and ETFs, you could suffer unrecoverable losses if the prices of the underlying bonds held by the funds decrease in value.

“It’s a market where investors can benefit from professional advice,” Ghriskey says. “As long as the advisers are experienced and don’t charge too much.”

Buying individual muni bonds can be expensive. You can buy them from discount brokers, but the trading commission is factored into the price rather than charged separately. So you don’t know what you’re paying in commissions.

So how much should you invest in individual municipal bonds? Michael Dixon says $25,000, at least. The director of planning and wealth management at Carl Domino in Palm Beach, Florida, says you’ll need least 20 different issues to gain adequate diversity.

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,” he says. “With mutual funds, holdings information is updated just once a quarter.”

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

“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.

Should you buy municipal bonds?

With a low default risk and generous tax exemptions, investing in municipal bonds might be right for you.

But be mindful that “low risk” doesn’t mean “risk-free.” While cities and local governments aren’t likely to default, there’s still a chance they might. When the city of Detroit declared bankruptcy in 2013, they forfeited their obligation to paying back bonds. Creditors swallowed $7 billion in losses. Before that, Jefferson City, Ala., declared bankruptcy in 2011.

Investments carry risk, regardless of what that investment is. Be mindful and cautious as you put your money into any investment, including municipal bonds.

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