What are municipal bonds?

There’s more to diversifying your income than just lowering your overall investment risk. Adding different types of investments, like municipal bonds, is a great way to utilize 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, making their returns more attractive. In some cases, city and state taxes are also exempt. Whether “muni” bonds make sense for you depends on your income, investment goals and risk appetite.

What are municipal bonds?

Municipal bonds are securities issued by local governments, such as a city, state, county or municipality. When you buy a muni bond, you’ll receive interest payments at regular intervals, typically 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 such as a new bridge or highway. The maturity of a muni bond typically ranges from one to 10 years.

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.

Types of municipal bonds

There are a couple of different types of muni bonds, including:

• General obligation (GO). These are issued by a government and allow the government entity to tax residents in order to pay back the bondholder. Some general obligation bonds are from general funds or backed by dedicated taxes, but they aren’t backed by revenue from a specific project.
• Revenue. These types of bonds are backed by a specific type of project or source. There are a lot of different types of revenue bonds, like those coming from colleges and hospitals, for example.

Pros and cons of municipal bonds

Pros

• Tax-exempt: Muni bonds are usually exempt from federal taxes and sometimes state and local income tax, meaning more money goes into your pocket. This makes muni bonds particularly attractive for investors in high tax brackets.
• Low volatility: Municipal bonds — while not completely risk-free — are one of the safest investments for your money.
• Minimal default risk: Since muni bonds are mostly safe and supported by tax revenues or usage fees, your default risk is very low.

Cons

• Market prices could tank: If interest rates go up, the market prices of existing bonds will go down. That means you could have to sell your bond at a loss.
• Not inflation-friendly: Municipal bonds don’t hold up against inflation as well as stocks do. When inflation rises, a muni’s fixed payment is less attractive.
• Still a chance of default: While default risk is very low, municipal bonds could still go into default. For example, the city of Detroit filed for Chapter 9 bankruptcy in 2013 — the largest municipal bankruptcy in U.S. history. Jefferson County, Alabama, another prominent example, filed in 2011.

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.

What to consider when investing in municipal bonds

Individual bonds vs. funds

One of the first questions for muni investors is whether to buy individual bonds, mutual funds or exchange-traded funds (ETFs). The advantage of buying individual bonds is that you could earn a higher total return, assuming the issuer doesn’t default. By contrast, with mutual funds and ETFs, you have a diversified portfolio of bonds and so the fund’s shareholders earn the weighted average return of those investments, which will be lower than the best-paying muni bonds.

Buying individual muni bonds can be expensive. That’s because the bond market tends to have wide bid-ask spreads, making it more expensive for investors in individual bonds to enter and exit a position. In contrast, when buying an ETF or mutual fund, the spread is narrow or even nonexistent, meaning you’re getting full value for your money.

Expenses are often lower for ETFs compared to mutual funds, but mutual funds carry some advantages over ETFs. While holdings in ETFs are usually based on a passively constructed index, managers at actively traded mutual funds can choose their holdings as they see fit, potentially generating higher returns than the index, though actively managed funds often underperform index funds.

In choosing a muni bond mutual fund, you want to start with ones that have a history of success. Look at how a fund has performed in down markets. Also look for funds with below-average expenses, as there are plenty of good ones available.

Your tax bracket

Investors in high tax brackets will benefit the most from holding municipal bonds because they’re avoiding being taxed at higher rates than those in lower tax brackets. When comparing the yield on a municipal bond to other bonds, you’ll want to calculate the tax equivalent yield, which adjusts a muni bond’s yield for the expected tax savings.

Tax equivalent yield = Tax exempt yield/(1 – marginal tax rate)

Asset location

Because municipal bonds come with tax advantages, it doesn’t make sense to hold them in tax-advantaged accounts such as a 401(k) or IRA. Income generated in those retirement accounts is already sheltered from taxes, so you won’t get the tax benefits of holding municipal bonds. It’s best to hold municipal bonds in taxable accounts such as a brokerage account.

Bottom line

With a low default risk and generous tax exemptions, municipal bonds can be a good choice for an investor’s portfolio.

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

— Bankrate’s Brian Baker contributed to an update.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.