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investopedia.com
The Basics of Municipal
Bonds
By Nick K. Lioudis
7-9 minutes
What Are Municipal Bonds?
If your primary investing objective is to preserve
capital while generating a tax-free income
stream, municipal bonds are worth considering.
Municipal bonds (munis) are debt obligations
issued by government entities. When you buy a
municipal bond, you are loaning money to the
issuer in exchange for a set number of interest
payments over a predetermined period.1 At the
end of that period, the bond reaches its maturity
date, and the full amount of your original
investment is returned to you.
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How Municipal Bonds Work
While municipal bonds are available in both
taxable and tax-exempt formats, the tax-exempt
bonds tend to get the most attention because the
income they generate is, for most investors,
exempt from federal and, in many cases, state
and local income taxes.2 Investors subject to the
alternative minimum tax (AMT) must include
interest income from certain munis when
calculating the tax and should consult a tax
professional prior to investing.3
Key Takeaways
Municipal bonds are good for people who want to
hold on to capital while creating a tax-free
income source.
General obligation bonds are issued to raise
funds right away to cover costs, while revenue
bonds are issued to finance infrastructure
projects.
Both general obligation bonds and revenue
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bonds are tax-exempt and low-risk, with issuers
very likely to pay back their debts.
Buying municipal bonds is low-risk, but not risk-
free, as the issuer could fail to make agreed-
upon interest payments or be unable to repay the
principal upon maturity.
Types of Municipal Bonds
Municipal bonds come in the following two
varieties:
general obligation bonds
revenue bonds
General obligation bonds, issued to raise
immediate capital to cover expenses, are
supported by the taxing power of the issuer.
Revenue bonds, which are issued to fund
infrastructure projects, are supported by the
income generated by those projects. Both types
of bonds are tax-exempt and particularly
attractive to risk-averse investors due to the high
likelihood that the issuers will repay their debts.4
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Credit Risk Levels of Municipal Bonds
Although buying municipal bonds is low-risk, they
are not entirely without risk. If the issuer is
unable to meet its financial obligations, it may fail
to make scheduled interest payments or be
unable to repay the principal upon maturity. To
assist in the evaluation of an issuer's
creditworthiness, ratings agencies (such as
Moody's Investors Service and Standard &
Poor's) analyze a bond issuer's ability to meet its
debt obligations and issue ratings from 'Aaa' or
'AAA' for the most creditworthy issuers to 'Ca',
'C', 'D', 'DDD', 'DD', or 'D' for those in default.5 6
Bonds rated 'BBB', 'Baa', or better are generally
considered appropriate investments when capital
preservation is the primary objective. To reduce
investor concern, many municipal bonds are
backed by insurance policies guaranteeing
repayment in the event of default.
Every year, Moody's Investors Service publishes
"U.S. Municipal Bond Defaults and Recoveries,"
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a proprietary study on more than 10,000
municipal bond issuers it covers. The most
recent study covers defaults from 1970 to 2018.
Over the past 10 years, the average default rate
for investment grade municipal bonds was
0.10%, compared with a default rate of 2.28% for
similarly rated corporate bonds.7
Nevertheless, municipal bonds defaults are not
uncommon. There were 10 defaults in 2017,
seven of which were associated with Puerto
Rican debt crisis. A record $31.5 billion in bonds
were in default that year, up 15% from 2016.8
The 10-year average default rate for investment
grade municipal bonds was 0.10%, compared
with 2.28% for corporate bonds.7
Tax Bracket Changes
Municipal bonds generate tax-free income and
therefore pay lower interest rates than taxable
bonds. Investors who anticipate a significant drop
in their marginal income-tax rate may be better
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served by the higher yield available from taxable
bonds.
Call Risk
Many bonds allow the issuer to repay all or a
portion of the bond prior to the maturity date. The
investor's capital is returned with a premium
added in exchange for the early debt retirement.
While you get your entire initial investment plus
some back if the bond is called, your income
stream ends earlier than expected.
Market Risk
The interest rate of most municipal bonds is paid
at a fixed rate. This rate doesn't change over the
life of the bond. However, the underlying price of
a particular bond will fluctuate in the secondary
market due to market conditions. Changes in
interest rates and interest rate expectations are
generally the primary factors involved in
municipal bond secondary market prices.
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When interest rates fall, newly issued bonds will
pay a lower yield than existing issues, which
makes the older bonds more attractive. Investors
who want the higher yield may be willing to pay
more to get it.
Likewise, if interest rates rise, newly issued
bonds will pay a higher yield than existing issues.
Investors who buy the older issues are likely to
do so only if they get them at a discount.
If you buy a bond and hold it until maturity,
market risk is not a factor because your principal
investment will be returned in full at maturity.
Should you choose to sell prior to the maturity
date, your gain or loss will be dictated by market
conditions, and the appropriate tax
consequences for capital gains or losses will
apply.
Buying Strategies
The most basic strategy for investing in municipal
bonds is to purchase a bond with an attractive
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interest rate, or yield, and hold the bond until it
matures. The next level of sophistication involves
the creation of a municipal bond ladder. A ladder
consists of a series of bonds, each with a
different interest rate and maturity date. As each
rung on the ladder matures, the principal is
reinvested into a new bond. Both of these
strategies are categorized as passive strategies
because the bonds are bought and held until
maturity.
Investors seeking to generate both income and
capital appreciation from their bond portfolio may
choose an active portfolio management
approach, whereby bonds are bought and sold
instead of held to maturity. This approach seeks
to generate income from yields and capital gains
from selling at a premium.
Evaluating Stability vs. Fit
Stability is a relative term in the municipal bond
market. Municipal bonds tend to be safer than
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many other types of investments, but they are
less safe than U.S. Treasury bonds.9 You can
also trade in multiple kinds of municipal bonds,
such as assessment bonds, revenue bonds, or
general obligation bonds.
The issuer of the bond also matters; bonds
issued from municipal authorities in a city with
strong financials would be considered more
stable than those from a city whose credit rating
has been downgraded or has recently filed for
bankruptcy.
Plenty of investors make an understandable
mistake during tough or uncertain times and
develop tunnel vision about stability and safety.
In their flight from risk, however, they fail to
consider how an investment fits into their
financial plans.
Municipal bonds can be a tax haven, often
generating higher returns than Treasuries. They
can still lose to inflation and tie up large sums of
money for much longer than a recession typically
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lasts.
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