Are you—or would you like to become—a municipal bond investor? Understand the basic types of municipal, or muni, bonds and the potential benefits and risks.
Municipal bonds, aka munis, may not come to investors’ minds every day. But muni bonds are at work all around us, providing funds to build roads, bridges, parks, schools, and other things. Many of the infrastructure projects in the United States are funded by muni bonds.
Tax-advantaged muni bonds may be appealing for many investors, and muni bonds in general can be a valuable tool for a long-term portfolio strategy, according to Roza Shamailov, senior manager, fixed income trading and syndicate at TD Ameritrade. Investors should also be aware of a few caveats and risks of muni bonds. Let’s look at a few muni bond pointers for investors.
Muni bonds are interest-bearing debt obligations sold by a state, county, city, or other government agency or authority to potentially finance public capital projects. In addition to schools, roads, and bridges, these projects may include hospitals, jails, stadiums, and low-income housing.
Similar to Treasuries and other types of bonds, munis are debt securities. They’re traded on the bond market. The principal or original investment is predefined, along with the rate of return known as yield and an expiration known as maturity. Munis are fixed-income securities, which means investors expect to receive periodic interest payments (typically every six months) of a consistent amount until the bond matures. There are two main types of municipal bonds: general obligation bonds and revenue bonds. A general obligation bond is paid back through the taxing power of a state or local government. A revenue bond is paid back through the project’s ability to raise revenue and pay off debt.
In dollar terms, the muni bond market is a relative pipsqueak compared to its Treasury and corporate counterparts, but muni numbers are nothing to sneeze at. In 2021, the U.S. muni bond market had a total value of $3.9 trillion, according to Bloomberg.
By comparison, SIFMA reported that as of Q3 2021, the corporate debt market totaled $10 trillion.
Muni bond rates vary depending on a number of factors like maturity and creditworthiness of the entity selling the bonds. The most creditworthy muni bond issuers—those with the lowest risk of default—pay lower rates than the less creditworthy, which carry a greater risk of default. A AAA-rated muni bond—the highest possible rating—pays a lower rate than an A-rated muni, all else equal.
As for returns, muni bonds in recent years had a solid, if unspectacular, performance in the broader market scheme of things. From 2011 to 2021, the S&P Municipal Bond Index, which reflects the performance of more than 200,000 bonds, had posted an average return per year of about 3.7%, not accounting for tax-adjusted returns. The S&P 500® Investment Grade Corporate Bond Index grew 4.29%. Investors should keep interest rate changes and risks in mind before investing.
Interest earned on corporate or Treasury bonds is subject to Federal income taxes, but that’s not the case for most muni bonds. For investors, “the main advantage of investing in municipal bonds is earning interest that is generally exempt from Federal income taxes. It may also be exempt from state income taxes if the issuer is in your home state,” Shamailov said.
When comparing municipal bonds to other investments, Shamailov suggested investors consider “taxable equivalent yield,” also called the after-tax yield.
The after-tax yield accounts for tax consequences that incurred ordinary income, and because the interest on most municipal bonds is excluded from federal income taxes, the tax savings to the investor vary depending on an investor’s tax bracket and the yield on the bond.
For example, an investor in the 37% federal tax bracket considering a muni bond with a 2% yield would have to earn 3.08% on a taxable investment to equate to the 2% muni investment.
In this example, the taxable equivalent yield “is being factored using only the federal income tax exemptions,” Shamailov said. “State and local exemption would push the taxable equivalent yields on municipals higher, which would improve the appeal to investors in lower tax brackets.”
In other words, muni bonds aren’t free lunch. Investors should understand the potential tax implications before they dive into the muni market.
TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.
One risk in muni bonds is an issuer default—such as if a city or other government body declares bankruptcy or otherwise can’t pay its debts. That’s a relatively rare occurrence in the muni bond market.
In a study by Moody’s Investors Service going back to 1970, the 10-year cumulative default rate for all investment-grade munis was only 0.10% compared to 2.24% for all investment-grade corporate bonds that Moody’s rated.
Other risks include interest rate risk, meaning if interest rates rise, the value of outstanding munis will fall. Munis with longer maturities will usually decline more in price compared to munis with shorter-term maturities if rates rise.
“Historically, tax-advantaged muni bonds have been favored by investors in higher tax brackets,” Shamailov said.
Again, the interest earned on munis is generally exempt from federal income tax and, in many cases, is also exempt from state and local taxes for investors residing in the state where the bond was purchased. Tax-advantaged munis may also appeal to investors in retirement or approaching retirement. Interest income and capital gains on municipal securities may be subject to the Alternative Minimum Tax.