What are municipal bonds?
When talking about investing in government bonds, municipal bonds come up because they help fund projects for state and local governments. In many cases, these bonds are used to help fund expensive projects, usually related to infrastructure and buildings.
You purchase the bond, which is basically like making a loan to the city, county, or state government, and you receive regular interest payments from the bond. Later, when the bond reaches its maturity date, you get your principal back.
How to buy municipal bonds
The main issue when learning how to invest in municipal bonds is knowing how to buy them. It’s possible to purchase municipal bonds through a stock broker.
It’s also possible to access these investments by using mutual funds and exchange-traded funds (ETFs). With mutual funds, you own a slice of every investment included in the fund. So, if you find a bond fund that includes munis, you can be invested in those bonds and receive the advantages. On the other hand, ETFs don’t let you directly invest in municipal bonds, but you do get exposure to them. Plus, ETFs can be more accessible because they trade like stocks on an exchange, making them easier to invest in than mutual funds.
Carefully consider your options, as well as what you might have access to. In many cases, it’s possible to include municipal bonds in your portfolio without too much effort.
Types of municipal bonds
When you decide to learn how to invest in municipal bonds, it’s important to take a step back and understand the different types you can choose. In many cases, it’s common to receive interest payments every six months, but double-check to ensure that you understand when you’ll get the income, as well as know the maturity date.
For the most part, there are three main types:
1. General obligation bonds
General obligation bonds are usually backed by a taxing authority. Basically, the idea is that a government issues general obligation bonds to fund a big project. As tax revenue comes in, the bonds are paid back.
Before deciding to buy a general obligation bond, it’s important to take a look at the credit rating of the taxing authority. Local governments can go bankrupt, so make sure you’re investing in government bonds that are likely to be repaid.
2. Revenue bonds
The other main type of bond is a revenue bond. Instead of relying on taxes, revenue bonds are repaid with the money that comes from ratepayers over time. For example, let's say a water company issues revenue bonds. As the project generates revenue, the debt is repaid.
When considering revenue bonds, take a look at the project involved and what factors might influence whether the bond is repaid.
3. Double-barreled credit
Even though most municipal bonds are in either general obligation or revenue categories, some types of munis blend the different aspects. This is known as double-barreled credit. For example, a government entity might decide to build a toll road and issue munis to pay for it. On the one hand, the muni is backed by the taxing authority. But there are revenues from the tolls that can also contribute toward paying back the bonds.
Basically, if the revenue isn’t enough to cover the interest payments and repay the principal, the taxing authority steps in to make up the shortfall.
How are municipal bonds taxed?
One of the reasons that many investors want to learn how to buy municipal bonds is due to the tax advantages.
When you receive earnings from investments, you must pay taxes on those earnings. So when you invest in bonds, you pay taxes on the interest payments you receive. With municipal bonds, though, that isn’t the case. Muni earnings aren’t taxed at the federal level. Depending on where you live, and where you invest, your earnings might be tax-exempt at the state and city level as well. Read more about tax-efficient investing here.
Whether your municipal bond earnings are taxed at the state or local level depends on how the tax authority operates. In many cases, if you invest in munis used for projects in the state you reside in, it's unlikely that you will have to pay taxes on your interest earnings. Double-check with a tax professional to ensure that your bonds are actually tax-exempt.
How much can you make from municipal bonds?
As you think about how to invest in municipal bonds, you’re probably wondering how much you can make. Like any investment, the amount you earn depends on how much you invest. Other factors include market conditions and what yield the entity is offering.
In general, though, yields on municipal bonds are often higher than U.S. Treasuries. Some munis might even have higher yields than some corporate bonds. Like other bonds, munis are considered somewhat less risky than stocks. As a result, you’re likely to see the potential for better returns with stocks than with municipal bonds.
If you decide to invest in municipal bonds, you can use them in different parts of your portfolio for various purposes. Some investors like them for the income potential, while others like the stability they provide. Figure out how much of your portfolio you want to be allocated to it. That can provide you a baseline to find out how much you can make from municipal bonds.
Municipal bonds are not money in your pocket
It’s also important to recognize that, like any other investment, there is the risk of loss. While investing in bonds, in general, is considered less risky, the reality is that you could still lose your principal. If the issuing authority goes bankrupt or has other problems, they might not repay the bond at maturity.
Additionally, even if there isn’t a problem with your principal, the muni may be called in early. As a result, you get your principal back ahead of time — and miss out on subsequent years of interest payments.
Add diversity to your portfolio with municipal bonds
Learning how to invest in municipal bonds can provide you with another way to add diversity to your portfolio. Additionally, the tax benefits of munis can help you make your portfolio more efficient in the long run. Carefully examine your situation and your long-term financial goals. And consider consulting with an investment professional before moving forward. With the right approach, municipal bonds might be a good addition to your portfolio.