Municipal Bonds: An Overview

If your primary goal as an investor is to protect your capital while generating a tax-free income stream, municipal bonds, or “munis,” are an option worth exploring. Municipal bonds are debt instruments issued by government entities, offering a secure investment. When you purchase a municipal bond, you are effectively lending money to the issuer, who, in return, provides you with regular interest payments over a set period. Once this period ends and the bond matures, you get back the total amount of your original investment, ensuring the safety of your capital.

How Municipal Bonds Work

Municipal bonds come in taxable and tax-exempt forms, with the latter being the most attractive to investors due to the significant tax benefits. For most investors, the income generated by these bonds is exempt from federal taxes and, often, from state and local income taxes. However, it’s important to note that investors subjected to the Alternative Minimum Tax (AMT) must account for the interest income from certain municipal bonds when calculating their tax obligations. It’s recommended that such investors consult with a tax advisor before investing.

Key Takeaways

• Tax-free income and capital preservation: Municipal bonds are ideal for investors looking to preserve their capital while generating tax-free income.
• Types of bonds: General obligation bonds are issued to cover immediate expenses, while revenue bonds finance infrastructure projects. Both types are typically tax-exempt and low-risk, with the issuers likely to repay their debts.
• Low-risk, not risk-free: Although municipal bonds are generally safe investments, there’s still a risk that the issuer may not meet interest payments or repay the principal when the bond matures.

Types of Municipal Bonds

Municipal bonds can be divided into two main categories:

General Obligation Bonds

These are issued to raise immediate funds for general governmental expenses. They are backed by the taxing power of the issuing entity, such as a city or state.

Revenue Bonds

These bonds finance specific infrastructure projects, like toll roads or utilities, and are backed by the revenue generated from those projects.

Both types of bonds are typically tax-exempt, making them particularly attractive to risk-averse investors due to the high likelihood that issuers will repay their debts.

Credit Risk Levels of Municipal Bonds

Despite their generally low-risk nature, municipal bonds are not entirely risk-free. Suppose the bond issuer cannot meet its financial obligations. In that case, they may fail to make scheduled interest payments or repay the principal at maturity. Credit rating agencies, such as Moody’s Investors Service and Standard & Poor’s, assess an issuer’s ability to repay debts and assign ratings. These range from ‘Aaa’ or ‘AAA’ (highest creditworthiness) to lower ratings such as ‘Ca,’ ‘C,’ or even ‘D’ for issuers in default.

• Investment Grade Bonds: Bonds rated ‘BBB,’ ‘Baa,’ or higher are considered safe investments, especially when the primary goal is capital preservation.
• Insurance-backed Bonds: To further reduce investors’ risk, many municipal bonds come with insurance policies that guarantee repayment even if the issuer defaults.

Every year, Moody’s Investors Service publishes a report titled “U.S. Municipal Bond Defaults and Recoveries,” which studies municipal bond issuers. For instance, between 1970 and 2020, investment-grade municipal bonds had a meager average default rate of 0.10%, while similarly rated corporate bonds had a much higher default rate of 2.25%.

Municipal Bond Defaults: While the risk of default is low, it is not unheard of. In 2017, 10 municipal bond defaults were recorded, seven of which were linked to Puerto Rico’s debt crisis. That year, a record $31.15 billion worth of bonds went into default, marking a 15% increase from 2016.

Tax Bracket Changes

Because municipal bonds offer tax-free income, they tend to pay lower interest rates than taxable bonds. For investors expecting a significant reduction in their income tax rate, the higher yields offered by taxable bonds might be a more appealing option.

Call Risk

Many municipal bonds come with a “call” feature, allowing the issuer to repay the bond before its maturity date. If this happens, the investor receives their capital back, sometimes with a premium as compensation for the early repayment. However, while you may benefit financially from this early call, your anticipated income stream will end sooner than expected.

Market Risk

Municipal bonds often pay a fixed interest rate, which remains unchanged throughout the bond’s life. However, the bond’s price can fluctuate in the secondary market based on overall market conditions. Changes in interest rates typically have the most significant impact on municipal bond prices.

• Falling interest rates: When interest rates drop, newly issued bonds offer lower yields than older bonds, making the latter more valuable. Investors may pay a premium to buy these older bonds with higher yields.
• Rising interest rates: Conversely, if interest rates rise, new bonds offer higher yields, making older bonds less attractive unless they are sold at a discount.

Suppose you hold your municipal bond until it matures. Market risk won’t affect you in that case, as your principal will be fully returned. However, suppose you sell the bond before maturity. In that case, market conditions will determine your gain or loss, and you must account for capital gains or losses when filing taxes.

Buying Strategies

There are several strategies to consider when investing in municipal bonds:

• Buy and hold: The most straightforward approach is to purchase a bond with an attractive interest rate or yield and hold it until maturity. This passive strategy offers a stable income stream over time.
• Bond laddering: A more advanced strategy is bond laddering, where you purchase bonds with different interest rates and maturity dates. As each bond matures, you reinvest the principal in a new bond, creating a consistent income stream over time. This approach also helps diversify the portfolio across varying market conditions.
• Active management: Some investors prefer an active management approach, where bonds are bought and sold instead of held until maturity. This strategy aims to generate income from interest payments and capital gains from selling bonds at a premium.

Evaluating Stability vs. Fit

While municipal bonds are generally considered safe investments, they’re less secure than U.S. Treasury bonds. The stability of the bond issuer is also essential. For example, bonds issued by municipalities with strong financial health are safer than bonds issued by cities facing economic hardship or those that have filed for bankruptcy.

Many investors, particularly in uncertain times, focus too much on stability, often overlooking how well a particular investment aligns with their financial goals. Municipal bonds can serve as tax shelters and usually offer higher returns than Treasuries. However, they still carry risks, including inflation-eroding returns or the potential for funds to be tied up for long periods.

Conclusion

Municipal bonds offer a relatively low-risk way to preserve capital while generating a tax-free income stream, making them appealing to conservative investors. While general obligation and revenue bonds come with distinct structures, both provide tax-exempt income and a high likelihood of repayment. However, as with any investment, municipal bonds carry some risks, including credit, call, and market risks. Understanding these factors and choosing the right passive or active strategy can help investors maximize the benefits of municipal bonds within their broader financial plan.