Municipal Bonds (or Munis) are issued by state and local governments to finance the construction of schools, highways, bridges, sewers and other public works. Municipal Bond Income is free from federal taxes, and if you live in the municipality that issued the bond, free of local taxes. For example NYC Munis are ‘triple-tax-exempt’ (free of federal, state and city taxes.) when purchased by a resident of the city.
Typically munis pay out about 20% less than Treasuries, but after allowing for the tax breaks that come with munis, the two are generallly in line. So Munis are most attractive to high-income investors seeking tax-free income that’s theirs to keep.
Types of Munis
Municipal bonds come in two main flavors:
General Obligation Bonds
These are backed by the ‘credit and taxing power’ of the issuing body.
These are issued to support a particular infrastructure project, and backed by the envisaged revenue from the same project.
General Obligation Bonds are considered more creditworthy than Revenue Bonds. Other types of municipal bonds exists (with esoteric names such as floater bonds, housing bonds, special tax bonds, and lease revenue bonds) but these are best avoided unless you fully understand their nature.
As with all investments, Munis come with certain risks:
Firstly credit risk
. Munis are relatively secure, being just a level down from treasuries in terms of safety. However there is a risk that the local government agency that issued the bond will be unable to pay the interest or refund your money at maturity. An example is Orange County in 1995, when investors lost over $1.5 billion when the county went into bankruptcy. Three major agencies give ratings to munis - Moody's Investors Service, Standard & Poor's Corporation (S&P), and Fitch Investors. The ratings typically varying from ‘AAA’ for the highest quality bonds down to ‘D’ to those in default. However the perceived credit risk of municipal bonds is very small. Currently the default rate on a triple-A-rated muni is basically zero (at less than 1 in 10,000).
The second type of risk is interest rate risk
. Interest rates may rise and new bonds will pay a better rate than the existing ones.
Lastly, and this does not apply to all bonds, there's call risk
. A bond may have a 'call provision'. This means the bond issuer can refund the bond early. This normally happens when interest rates are very low, making it a bad time for re-investment.
Investing in Munis
You can pick from buying individual bonds, muni mutual funds, and muni ETFs. Most securities dealers are registered with the Municipal Securities Rulemaking Board (MSRB) and are able to deal in all 3 types of investment.
Individual Bonds typically come with face maturities of 5, 10 or 20 years, and require a minimum investment of $5000. You may also be able to purchase bonds at the time of issue by following the advice from your local government. Alternatively you can purchase a bond at any time in its life cycle. This is best done via a local broker. Commission on buying individual bonds is typically between 0.5% and 1%. After purchasing the bonds, you’ll receive a regular tax-free income. You can sell the bonds at any time via a dealer, or wait till maturity when the face-value of the bonds will be fully refunded on presenting the matured bonds to your local authority. (Do this quickly because no interest will be paid on the bond after maturity). An advantage of individual bonds (though this may be derided by investment professionals) is the satisfaction that comes with investing in local projects.
Mutual funds and ETFs are collective investments, where your fund is diversified across several funds and maturity timescales (but each fund is state specific). Generally the minimum investment is small, but dealing costs can vary from a moderate 0.5% up to a heinous 3%). There’s also the spread to consider (the difference between the buying and selling price), and the annual management charge. Funds and ETFs don’t mature, but can be sold as and when required.