A guide to municipal bonds and how to buy them
Editorial staff, J.P. Morgan Wealth Management
- Municipal bonds, also known as muni bonds or “munis,” are loans extended by investors to city, state or local governments in exchange for regular interest payments. The issuer pays the principal back at the bond’s maturity date.
- Municipal bonds are typically issued to fund major infrastructure projects, such as highway systems, airports and schools.
- As federal interest rates rise, bond prices typically fall; consequently, newly issued bonds come with higher coupon rates, which may make them attractive for investors.
Because they’re issued by city, state or local governments, municipal bonds are widely considered relatively safe investments. However, they are not without risk. Investors should carefully consider all risks before investing. Accessible to beginner and advanced investors alike, municipal bonds may offer certain tax advantages that could help bondholders manage risk while still earning income.
Understanding how municipal bonds work – and when it makes sense to invest in them – can help you decide if they have a place in your overall investment strategy.
What are municipal bonds?
Municipal bonds are essentially loans that an individual makes to a government entity, such as a state, city or county. The bond issuer uses the loaned money to fund large capital projects. In return, the issuer pays the investors – bondholders – interest at regular intervals, usually semiannually, and returns the principal at the bond’s maturity date. Investors can purchase short-term municipal bonds that mature after one to three years, or long-term bonds that last a decade or more.
Before investing in municipal bonds, investors should first understand the different types available. The two most common are general obligation bonds and revenue bonds.
- General obligation (GO) bonds: These municipal bonds aren’t secured by government assets but by the “full faith and credit of the issuer” – a city, county or state. The issuer may have the power to tax residents to repay bondholders, so GO bonds may be seen as generally safe investment options, though they are not risk-free.
- Revenue bonds: These municipal bonds are backed by government projects that generate revenue, like a tolled highway or bridge, or by some other source of income. Revenue bonds are not backed by the issuer’s full faith and credit, so they’re considered riskier than GO bonds.
Although government-issued bonds are thought to be relatively safe, investors should know that the financial health of the issuing government can affect bonds’ price and risk. And just like with any investment, there are risks that come with investing in municipal bonds.
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Who issues municipal bonds?
As mentioned above, cities, counties, states and other local government entities issue municipal bonds primarily to fund important projects that benefit the public. Projects might include highways, bridges, airports, libraries, schools, parks, hospitals, courthouses, power plants and water treatment facilities. Bond money may also be used to pay for daily obligations and workings within the government.
With municipal bonds, governments can provide critical services while spreading the costs across multiple generations, easing the burden on current taxpayers. For example, when a toll bridge is built using money borrowed from current bondholders, future drivers who pay the bridge tolls are effectively contributing to the payback of the original bond loan. This is especially true in the case of long-term municipal bonds.
What to consider before investing in municipal bonds
Now that you know what municipal bonds are and who issues them, let’s cover some additional details that may help you evaluate this investment option.
How interest rates affect municipal bonds
Bond prices and interest rates are inversely correlated; as interest rates rise, bond prices typically fall. The rate at which a bond issuer pays interest to the bondholder is known as the coupon rate. Coupon rates tend to increase as market interest rates increase. During periods of inflation, investors will be issued municipal bonds with higher coupon rates and subsequently paid higher interest through the term of the bond.
Municipal bonds purchased during periods of high interest rates may be worth more money down the road, as inflationary periods may be followed by a reduction in interest rates.
Municipal bonds are tax-efficient investments
Municipal bonds may be considered a tax-efficient investment option: The interest paid on them is generally exempt from federal income tax and may even be exempt from state and local taxes under certain circumstances.
There are times, however, when you may be taxed on municipal bonds – particularly if you buy them from a government entity outside your state of residence. In these cases, your state of residence may charge income tax on the bond interest payments you receive.
Additionally, if you choose to sell your bonds before they reach maturity, you may be subject to federal and state capital gains taxes. If you have any doubts, you should consult your tax advisor regarding their tax treatment.
How municipal bonds compare to corporate bonds
Corporate bonds tend to offer a higher interest rate than municipal bonds. The potential tax advantages of the latter, however, may make municipal bonds an option worth exploring. As with any investment tool, deciding what works for you is a balancing act of pros and cons.
The disadvantages of municipal bonds
While municipal bonds have many benefits, they also have some disadvantages to consider. Investors should understand the following risks.
- Call risk: Municipal bonds may have a call provision, which means the issuer can redeem the bond before it matures. If this happens and the interest rate is lower than when you purchased the bond, the issuer may reissue the bond with a lower interest rate.
- Liquidity risk: Municipal bonds can be less liquid than other securities, meaning they may be difficult to buy and sell quickly. This is especially true for bonds issued by smaller municipalities.
- Credit risk: While defaults on municipal bonds are rare, they can still occur, particularly for bonds issued by municipalities with weaker financial profiles.
How can investors buy municipal bonds?
Investors can buy municipal bonds through brokers, banks or bond dealers. You can invest in individual bonds, or you can buy a mutual fund or exchange-traded fund (ETF) that invests in municipal bonds.
Another way to acquire municipal bonds is by purchasing them through a brokerage account with your preferred financial institution. You can easily open an online brokerage account and fund it with money from a bank or investment account.
How much money do investors need to buy municipal bonds?
Municipal bonds are generally sold in minimum increments of $5,000. If you’re looking to buy municipal bonds for a lower cost, you may be able to invest in a mutual fund or ETF that buys municipal bonds.
The bottom line
Municipal bonds can be a solid choice for investors who are looking for stable, federal tax-free income with minimal risk. Potentially lower yields, though, may make municipal bonds less than ideal for those seeking aggressive long-term growth.
If you’ve been wondering how to buy municipal bonds or if this is an investment vehicle to consider, it may be helpful to connect with a J.P. Morgan financial advisor to explore your options.
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Editorial staff, J.P. Morgan Wealth Management
