Municipal bonds are debt security investments issued by government agencies to investors. Read informative tips on municipal bond investment strategies.
If you are knowledgeable with investing and finance and in a high-income bracket you might be searching for additional investment options with more defined terms. Municipal bonds are essentially loans investors extend to local government agencies to use toward applicable physical assets. Their tax-exempt status on the federal level (and largely on state and local levels) is only one out of many examples why municipal bonds offer unique benefits. Some risks are still involved, however. Therefore, it is advisable to research all angles the same as you would with any investment option. Continue reading for more detailed information on municipal bond investment strategies today.
Municipal Bond Fundamentals
Municipal bonds are a type of debt security, which are issued by municipalities, counties, and states to finance their respective capital expenditures (CapEx). Municipal bonds, also referred to as Munis, provide multiple unique benefits to investors. These fixed-income, interest bearing securities are potentially exempt from local, state, and federal taxes (conditions applying). Munis are excellent choices for investors who are hesitant to invest in riskier options. They are well suited for preserving wealth instead of increasing it through their maturity periods, which makes them an excellent choice for investors in higher tax brackets looking to preserve their assets.
How Do Municipal Bonds Work?
Essentially, a municipal bond is a loan an investor proffers to a government agency or institution. The funds are used to improve applicable infrastructure, including school systems, bridges, roadways, and sewer systems. Infrastructure also includes sixteen U.S. sectors identified by the Cybersecurity & Infrastructure Security Agency (CISA) as vital to national economics, health, safety, and security. The bonds are issued by the recipients of the investment funds in exchange for interest payments on the principal investment amount. Interest is typically paid in semi-annual frequencies although other interest payment terms sometimes apply. Both short and long-term municipal bonds are available. Short-term municipal bonds typically reach maturity within one to three years. Long-term municipal bonds commonly mature after ten years or longer.
Types of Municipal Bonds
Of the multiple types of available municipal bonds, two are most common. General obligation and revenue municipal bonds are the two most common. Tax-backed and conduit bonds are also available.
General obligation bonds are not asset-secured investments. This type of municipal bond is instead secured by the full credit and faith of the issuer. The issuer is also empowered to impose taxes on residents as a means of repaying the bondholders. For example, when funds from a general obligation bond are used to improve a local school system, applicable taxes might increase for residents living within the affected school district.
Revenue bonds are asset-secured investments. The issuer of this type of municipal bond is not empowered to impose taxes on residents. Interest is instead paid through revenue generated from the benefactor of the invested funds, such as a project, system or other relative source. Revenue bonds also have a unique risk. Non-recourse revenue bonds negate the claim bondholders have to their underlying revenue sources if the applicable stream of revenue ceases.
Tax-backed municipal bonds are repaid through taxes imposed upon revenue generated from sources such as tourism-based, tobacco and gasoline sales. Specialized tax assessments and incremental property taxes also generate revenue for tax-backed municipal bonds. Conduit bonds, also referred to as private activity or industrial development and revenue bonds, are purposed to benefit non-government-facilitated entities. Governments still issue the bonds, but the funds are used for organizations such as hospitals, non-profits, colleges, manufacturers, developers and more. The entity borrowing the investment funds is responsible for interest payments and full repayment of the principal - not the government agency issuing the bond. Additional types of municipal bonds include:
Variable rate demand obligations.
Certificates of Participation.
Original issue discount.
Municipal Bonds - Taxes
Most interest accrued on municipal bonds is granted a federal tax exemption. Investors who live in the state where the bond is issued might also benefit from local and state tax exemption on accrued interest as well. Because of their often tax-exempt status, interest payments applied to municipal bonds are typically lower than interest earned on other types of non-tax-exempt fixed-income securities (corporate bonds, for example).
Municipal Bonds - Understanding the Risks
While investing is chock full of general and specific risks, those associated with municipal bonds are generally low. Municipal bonds are effective, conservative investment options with low risk and moderate rewards, but some risks still do exist. Thankfully, risk of default by the issuer is not typically one of those risks. Instead, the primary risk associated with municipal bonds is a fluctuation in consumer trends. For example, it fair to say the treatment/improvement of municipality sewer systems or roadways bears more consumer interest (and likelihood of a return) than the development of a recreational facility’s shelter options. Credit, or default risks do exist, however. This risk is heightened specifically for non-recourse revenue bonds. Please note: All types of municipal bonds are susceptible to even a small degree of default risk. Therefore, and as always, be certain to thoroughly read and understand all terms before making this (or any) type of investment. Additional risks associated with municipal bond investing include:
Call (when an issuer repays the bond prior to its maturity date).
Inflation (reduces purchasing power on fixed-rate interest yields; reduces market value for already-issued bonds).
Liquidity (lack of available market for the type of bond investors prefer to procure, especially at preferred prices).
Strategies for Investing in Municipal Bonds
While basic advice, remember to consider broker fees in addition to any tax implications. Brokers are typically compensated via markup on top of a bond’s cost to the applicable firm. Confirmation statements only sometimes disclose this markup, whereas conversely, they do disclose broker commissions. Be certain to read the confirmation statement to fully understand all charges assessed. This said, utilizing a no-commission and no-financial-incentive brokerage firm helps you earn maximum returns on municipal bonds.
Employ the services of a financial/investment adviser to help make the best, more informed decisions possible. If investing on your own be certain to invest via a self-managed account or online directly. Municipal bond mutual funds help diversify holdings, while also providing investors with an equity share of their invested funds. Another reliable strategy is to invest in an exchange-traded fund (ETF). These bonds trade in ways like stocks within regular market trading hours, giving more trading timeframe options than municipal bond mutual funds, which are only bought and sold once per day.
A top resource for reliable market-wide information pursuant to municipal bond investing is the Electronic Municipal Market Access (EMMA) website. EMMA provides information on yield curves, third-party indices, and overall trading pattern statistics. The latter also includes information on securities with the current-most activity. EMMA also provides information on imminent municipal bond opportunities, reporting on upcoming economic trends/statistics and political contribution disclosures. More specific information about municipal bonds is available from each applicable issuer, or through a broker.