Exploring the Benefits and Investment Strategies of Municipal Bonds

Couple Exploring the Benefits and Investment Strategies of Municipal Bonds

Key Takeaways

• Municipal bonds provide tax-exempt income, making them appealing to high-income investors seeking stable, low-risk returns.

• There are multiple avenues to invest in municipal bonds, depending on your financial objectives, risk tolerance, investment expertise, and desired level of portfolio control.

Municipal bonds, commonly referred to as “munis,” offer a unique blend of tax benefits, income stability, and relatively low risk, making them a preferred option for investors interested in consistent income—particularly those in higher tax brackets.

Although municipal bonds may seem daunting to first-time investors, their capacity to deliver a predictable stream of tax-exempt income presents a distinctive and potentially advantageous opportunity, especially for high-income individuals in high-tax states.

This overview examines the functioning of municipal bonds, their advantages and disadvantages, and the various methods of investing in munis.

Purchasing a municipal bond involves lending money to the issuing authority—such as a state, local government, or school district—to finance public projects like schools, hospitals, and highways. In return, the issuer commits to paying interest throughout the bond's term and returning the principal upon maturity.

How Do Municipal Bonds Work?

Similar to bonds issued by the federal government or corporations, municipal bonds are debt instruments—funds lent by investors to states, counties, cities, and nonprofit organizations for public projects or debt refinancing.

In exchange for the loan, the municipality pledges to pay interest—typically semiannually—and return the principal on a specified date, known as the maturity date, assuming no default occurs.

Types of Municipal Bonds

Municipal bonds generally fall into one of two categories, based on the source of their interest payments and principal repayments. Within these categories, municipal bonds can be structured in various ways, each offering different benefits, risks, and tax implications.

General Obligation Bond

These bonds are issued by states, cities, or counties and are backed by the government's authority to tax residents to fulfill bondholder obligations.

Revenue Bond

These bonds are supported by revenues from a specific project, such as a toll road or utility initiative.

Advantages of Municipal Bonds

Municipal bonds offer several attractive benefits, particularly for income-focused investors seeking tax efficiency.

Tax Advantages

The interest earned from most municipal bonds is typically exempt from federal income tax and may also be exempt from state or local income tax, depending on your residency relative to the bond's issuing state. A small percentage of municipal bonds are federally taxable.

All or part of the income might be subject to the federal alternative minimum tax. Income from capital gains is generally subject to both state and federal taxes. This hypothetical example illustrates annual income from a $10,000 investment in a taxable account and its impact under the four highest federal tax rates. The municipal bond investment assumes a 2.63% yield, while the taxable US Treasury yield is assumed to be 4.34% (data from Refinitiv TM3, as of 11/30/23). This example is illustrative only; actual investments may differ. It does not account for state taxes, federal/state alternative minimum taxes, tax credits, exemptions, fees, or expenses. After-tax income may be lower if these were included. Please consult a tax advisor for further details.

Low Level of Default Risk

Credit risk involves the possibility of the issuer defaulting or failing to meet principal or interest payments. While many municipal bonds hold high credit ratings and have historically lower default risk compared to corporate bonds, credit risk increases with lower-rated municipal bonds.

Disadvantages of Municipal Bonds

Despite their tax advantages and stability, municipal bonds come with trade-offs that investors should carefully evaluate.

Interest Rate Risk

As with all fixed-income securities, municipal bond market prices are sensitive to interest rate fluctuations. Rising interest rates generally lead to declines in the market prices of existing bonds, regardless of unchanged coupon rates and maturities. Bonds with longer maturities are typically more affected by interest rate changes than those with shorter maturities.

Call Risk

Many municipal bonds include provisions allowing the issuer to call or redeem the bond before its maturity date. Issuers typically call bonds when interest rates fall, enabling them to reissue bonds at a lower borrowing cost, which can make reinvestment less favorable for bondholders.

Liquidity Risk

The bond market's size and fragmentation, with over 50,000 entities issuing millions of bonds, result in the vast majority of municipal bonds not being regularly traded, potentially affecting the liquidity of a specific bond.

How to Buy Municipal Bonds

Investors typically gain exposure to municipal bonds through three main methods.

Individual Bonds

You can purchase a single municipal bond starting at $5,000, but creating a comprehensive bond portfolio may require a significantly larger investment.

There are two methods to acquire individual bonds:

• New Issues: These are municipal bonds offered for the first time, such as when a city issues bonds to finance a new school. Investors can purchase these directly from the issuer or through a broker, at the same price as large institutions.

• Secondary Market: This market involves the buying and selling of existing municipal bonds after their initial issuance. For example, an investor might purchase a 10-year municipal bond from another investor five years after it was issued. Prices in this market vary based on interest rates, credit ratings, and demand. Bonds can be bought or sold through brokers, with prices including a broker's trading fee—termed a markup for purchases and a markdown for sales.

Purchasing individual municipal bonds involves evaluating the value of each bond and selecting among various issuers, yields, durations, and risk profiles.

Bond Funds and ETFs

Bond funds enable investors to access a diversified bond portfolio with a low minimum investment. Mutual funds and ETFs focused on municipal bonds typically fall into three categories:

• National Municipal Funds: These invest in bonds issued by different state and local governments. The income is generally exempt from federal taxes, though some may be subject to state and local taxes and the federal alternative minimum tax (AMT).

• State Municipal Funds: These funds primarily invest in bonds from a specific state, encompassing long, intermediate, and short-duration bonds. Income is usually exempt from federal taxes and may also be state tax-exempt, depending on the investor's residence.

• Municipal Money Market Funds: These allocate at least 80% of assets to municipal securities with interest exempt from federal income tax.

ETFs

Nationally focused municipal bond ETFs with a 5-star Morningstar rating include:

• Overlay Shares Municipal Bond ETF (OVM)

• iShares Intermediate Muni Income Active ETF (INMU)

• iShares High Yield Muni Income Active ETF (SHYM)

• PIMCO Municipal Income Opportunities Active ETF (MINO)

• ALPS Intermediate Municipal Bond ETF (MNBD)

• Eaton Vance Short Duration Municipal Income ETF (EVSM)

Separately Managed Account (SMA)

An SMA offers professional active management along with the benefits of direct ownership. Unlike mutual funds, where investments are pooled, SMAs provide direct ownership of individual bonds, offering greater transparency, control, and a personalized investment experience tailored to financial goals.

How to Decide

The most suitable way to invest in municipal bonds depends on your financial objectives, risk tolerance, investment expertise, and desired level of portfolio control. Key considerations include:

	Individual Bonds	Bond Funds/ETFs	SMAs
Minimum Investment	Typically $5,000 per bond, with a diversified portfolio possibly requiring $100,000 or more.	Low minimums (as little as $100 or less).	High minimums (Fidelity’s SMA offering requires $350,000).
Liquidity	Less liquid; may be challenging to sell at a fair price before maturity.	Highly liquid; can be bought or sold daily at NAV.	Less liquid than funds, but more flexible than individual bonds.
Transparency	Full transparency—you know exactly what you own.	Less transparent; holdings change frequently.	High transparency; you can see all holdings.
Cost	No ongoing fees, but may include small markups, such as $5 per $5,000 bond in the secondary market.	Expense ratios (typically 0.1%–1% annually).	Management fees (often 0.25%–1% annually) but may offer institutional pricing on bonds.
Expertise Needed	Requires knowledge of credit risk, duration, and market conditions.	Professionally managed—suitable for hands-off investors.	Professionally managed but tailored to your preferences.

Municipal bonds and bond funds are most advantageous in taxable accounts, such as brokerage accounts, due to their tax-exempt interest income. Holding them in tax-advantaged accounts like IRAs or 401(k)s can negate this benefit, as these accounts already offer tax advantages.

Therefore, municipal bonds are generally better suited for brokerage accounts, although there may be instances when taxable municipal bonds are appropriate for retirement accounts.

The Bottom Line

Municipal bonds can be beneficial for certain investors, including:

• Retirees or near-retirees seeking tax-exempt income with low risk.

• Those who have maximized their tax-advantaged accounts—IRAs and 401(k)s—and are seeking additional tax benefits.

• Residents of high-tax states, where tax-exempt income can significantly impact.

Consider whether municipal bonds align with your overall investment strategy, risk tolerance, and tax situation before incorporating them into your portfolio.

Investors can not only gain valuable returns and diversification from municipal bonds but also experience pride and satisfaction knowing their investments support local schools, hospitals, and essential services funded by municipal bonds.

Best Regards,

Stock Market Charlie