Quick look: Best municipal bonds
- Best high-yield municipal bond fund: Nuveen High Yield Municipal Bond Fund
- Texas bonds
- Washington bonds
- New York bonds
- Florida bonds
- Georgia bonds
What is a municipal bond?
Municipal bonds are debt instruments issued by states or municipalities that allow them to borrow money for a specific purpose. The funds raised by a bond sale might be used to build roads or improve infrastructure, build schools, or might even support projects that are beneficial to the community, such as hospitals or health centers.
Municipal bond defaults are possible but extremely rare. A bond default occurs when the bond issuer fails to make a payment toward interest or principal within a specified period. U.S. Treasury bonds are generally regarded to be the safest type of bond investment but generally don’t provide the same rate of return as municipal bonds and don’t have the same tax advantages found with municipal bonds.
Municipal bond advantages
Investing in municipal bonds bring several advantages when compared to other types of investing as well as providing some advantages over other types of bonds.
If you follow U.S. Treasury market yields, you know that yields don’t change much on a day-to-day basis and are generally on par with the dividend yield of the S&P 500.
- U.S. Treasuries range from under 2% up to just under 3%, with a higher yield only available for 30-year notes. Municipal bonds generally offer a more attractive yield.
- The highest-rated bonds, AA or AAA, can be higher than the 30-year treasury note, but with a shorter time to maturity.
- Municipal bond yields are typically higher when the bond rating is lower or the duration is longer.
- A lower bond rating can represent a potential for risk and longer-term bonds can have opportunity costs because interest rates can change over time, possibly making the bond less attractive as an investment.
- Step down one rating to BBB rated bonds (which are still considered to be investment grade bonds) and you’ll find higher yields with a slightly higher chance of default, typically around 1% after 10 years.
- Dropping below a BBB rating for bonds can be a risky proposition, as you end up with with default rates high enough to threaten the bond yield
It’s important to note that a bond’s yield is really a yield to maturity. When bonds are resold, the selling market often prices in changes in interest rates and other factors, causing a divergence between the yield and the coupon rate.
Sometimes the IRS can be friendly to investors, particularly in the case of municipal bonds, which are exempt from federal income tax. If you buy bonds issued in your home state, you can expect the interest you earn to be exempt from state taxes as well. If you’re in a higher tax bracket or if you plan to be at some point, municipal bonds can be a great addition to your portfolio because the yield isn’t taxable, making it equivalent to a higher yield in taxable investments, such as the yields of corporate bonds, treasury notes, interest from CDs, or stock dividends.
Secured by taxing authority
Many municipal bonds are structured general-obligation bonds, which means they’re supported by the full taxing authority of the issuer. States or municipalities can raise taxes as needed to meet their financial obligations including bond payments. Revenue bonds are another type of municipal bond – but rather than being paid through general revenues generated by states or municipalities, revenue bonds are paid off through the revenue from specific projects for which the bonds are issued, such as a toll bridge.
Municipal bond disadvantages
Prices for bonds can be just as volatile as prices for equities due to changes in risk or changes in interest rates. A bond purchased during a low interest rate environment may see its value adversely affected if interest rates go up because better earning opportunities are available in a higher interest environment. If your goal for investing in municipal bonds is a buy-and-hold strategy, volatility shouldn’t be a concern because you’ll be holding the bond until maturity. Once it’s mature, you’ll be paid the full principal.
Potential for default
Municipalities don’t often go out of business, but they can find themselves in financially challenging situations that can prevent the state or municipality from making required payments on the interest or principal for issued bonds.
In 2014, a federal judge approved a bankruptcy plan for Detroit which left some bondholders holding bonds of questionable worth. In 2016, Puerto Rico defaulted on $58 million in debt, and since the recent hurricane impacted Puerto Rico, the future of its bond payments remains uncertain.
Alternatives to bond funds
As a municipal bond investor, there are several ways in which you can invest. You can:
- Purchase bonds individually,
- Invest through a bond fund managed by a mutual fund company,
- Purchase municipal bond ETFs or
- Invest in unit investment trusts.
Municipal bond funds
Most mutual fund companies now offer bond funds in addition to mutual funds that specialize in groups of equities or indexes. Investors can expect the fund to be managed by a team or manager, trading bonds in or out of the fund’s portfolio based on market conditions or price direction, or even based on changes in risk. Passive funds are also available and usually seek to track of a bond index.
Many municipal bond funds offered through mutual fund companies provide overall ratings and risk profiles for the funds as well as a projected yield, but because bonds held by the fund can and do change often, it can be difficult to know exactly what you’re buying or if the bonds the fund held when you purchased shares are still part of the portfolio.
Municipal bond funds can be open-end or closed-end funds, with closed-end funds trading like stocks through any brokerage account.
The wide availability of bond funds through IRAs or 401(k) accounts help to drive the popularity of mutual bond funds. Active management by a team or fund manager also remove the need to become a bond expert, making investing in bonds through mutual funds a popular choice.
Municipal bond ETFs
Exchange traded funds (ETFs) are similar to mutual funds but are openly traded on an exchange. There’s no need to establish an account with a mutual fund company because ETFs trade just like stocks and are accessible from any trading account. Like bond mutual funds, bond ETFs can be passively managed, tracking a bond index, or can be actively managed by a fund manager or team.
Unit investment trusts
A unit investment trust is structured similarly to a mutual fund. The trust is an investment firm or company that bundles similar assets into units, which are then sold to investors. This may sound a lot like shares of mutual funds – and it is. Unit investment trusts can be used with stocks or with bonds, or even bond derivatives, and can specialize in certain types of bonds, such as municipal bonds.
With a unit investment trust structure, you don’t own the bonds directly. The trust owns the bonds and you own units within the trust. The largest distinction between unit investment trusts and mutual funds is that the bonds held by a unit investment trust are held until maturity. Bond funds managed by mutual fund companies typically trade in and out of bond investments according to the stated objectives of the bond fund. Unit investment trusts are best for the buy-and-hold investor because maturity dates can range up to 30 years from purchase date.
What to look for in municipal bonds
BBB rating or higher
Default rates for bonds rated BBB are slightly over 1%, with bonds rated A, AA, or AAA, boasting a default rate well below 1%. Higher risk bonds, even as part of a diversified portfolio, can destroy the overall bond portfolio yield if any of the bonds default. Moody and S&P use a slightly different convention for the rating nomenclature, but both lead the rating name with letters, A, B, C, etc.
Taxable equivalent yield
Compare yields for municipal bonds to their taxable equivalents for bonds with similar ratings. In many cases, you’ll find that the taxable equivalent yield of municipal bonds will make munis a more attractive choice.
General obligation bonds
General obligation bonds are effectively secured by the taxing authority of the issuer. This means that the state or municipality can raise taxes to meet its financial obligations, including bond payments.
What to carefully watch
Bonds rated lower than BBB
The default rate for municipal bonds begins to skyrocket for bonds rated BB or lower, with bonds rated C or lower sometimes having staggeringly high default rates.
Yields too good (or bad) to be true
If the yield from a municipal bond seems too good to be true, check the bond rating from Moody or S&P. High yields and lower bond ratings can go hand-in-hand. Also check the coupon amount. Bonds that are traded after issuance can have posted yields that don’t make quite as much sense as the coupon rate. A higher yield can be a more profitable bond investment – but only if the state or municipality doesn’t default on its debt obligations.
Revenue bonds pay bondholders from revenue generated from the project for which the bond was issued. This isn’t necessarily a bad thing, but it can create additional risk. State and local governments might be good at governing (or not) but that’s not a guarantee that any revenue-based ventures will be successful, potentially creating a risk that bond obligations won’t be paid.
How we chose the best municipal bonds
Here’s the bad news – but it’s not all bad. The best municipal bonds are usually sold quickly to brokers, funds, banks, or institutional investors, often leaving the retail investor grasping at empty space where the bonds once were or digging around for odd lots.
Nevertheless, we used the following information to choose the best of the best:
We also took reserves into consideration, which can provide insight into how well a state can navigate the next recession. States with some extra money in the bank may be more likely to meet their debt obligations without missing a beat.
Best municipal bonds
Best high-yield municipal bond fund: Nuveen High Yield Municipal Bond Fund
For the risk takers out there, high-yield municipal bond funds can offer a greater return than other options. The tradeoff is risk. High-yield funds usually invest at least 50% of their assets in bonds or derivatives that either aren’t rated or are rated BBB – and sometimes lower.
With a 6.42% average return for the past three years and a five-star Morningstar rating, the Nuveen High Yield Municipal Bond Fund is a strong performer, especially when you consider its tax-free earnings. High-yield funds have their risks, resulting in volatility in returns from year to year, but Nuveen’s high yield muni fund is a solid pick to help boost earnings in a diversified portfolio. The fund places its focus on non-investment-grade or unrated municipal bonds and targets opportunities resulting from bond market inefficiencies.
Best states for muni bonds:
Texas isn’t just for sunshine and armadillos, it’s also a great place to buy muni bonds. Texas residents don’t pay a state income tax, so there’s no (extra) tax advantage at the state level for Texas bond investors, but the state has a AAA rating and a booming economy to help fill state coffers with sales tax revenue. Yields for Texas General Obligation (GO) bonds are strong right now, often higher than the AAA-index, providing a prudent bond investment choice with an impressive return.
Many municipalities within Texas are also highly rated with attractive yields for low-risk investments. Bond investors should have no trouble finding muni bonds in Texas with ratings of BBB and higher and with coupon rates as high as 5% or more.
With its AA+ rating, Washington State is a safe bet for bond buyers. The state has reserves put aside for the proverbial rainy day, of which it has many, helping assure investors that its financial obligations will be met. We found a number of bonds for the state and for municipalities and projects within Washington that merit a closer look. Coupon rates ranged as high as nearly 10%. However, investors should invest time in learning more about each bond, particularly if the bond is revenue-based, which makes payments from revenue generated from the project.
The Empire State just might be the perfect place to start building your bond investment empire. New York has a hard-won AA+ rating, proving the state places priority on its credit commitments. New York is also in a strong position with reserves to help navigate a downturn. Coupon rates ranging up to nearly 13% are available for New York municipal bonds, but higher coupon rates are usually associated with municipalities or projects and may present more risk than bonds for the state itself or for lower-risk municipalities within New York. Bonds for some projects may also be taxable due to changes in tax law, so careful screening is required for bond investors.
Similar to Texas, Florida doesn’t have a state income tax, meaning bond investors from the Sunshine State won’t see an extra tax savings for buying Florida muni bonds. Bonds for Florida state and many of its municipalities and projects aren’t likely to sunburn investors. Florida is AAA rated and the state’s economy continues to grow faster than other parts of the nation, with a projected $1 trillion dollar Florida economy projected for 2018. Attractive coupon rates are available for a number of projects and municipalities, with coupon rates of 5% for bonds such as Florida DOT.
The Peach State can be a peach for bond investors as well. Georgia’s AAA rating puts the state in the lowest risk category. Growth in construction is helping fuel Georgia’s economy, but growth is also strong in medical fields and tech fields, leading to the highest employment rates in nearly 20 years. Muni bonds available for Georgia range from long-term bonds for projects with a high coupon rate to state-issued bonds, which make a secure investment with an attractive yield. Georgia, as another state with a strong reserve should be in a good position to weather a recession without missing a beat.
Most individual investors buy municipal bonds through a fund, which has its advantages, including liquidity and the benefit of a managed bond portfolio. The returns for municipal bonds can be higher, however, if purchased through a broker, particularly if your intent is to hold the bonds until maturity.
Not every bond is a great buy. Many of the bonds with the highest yields offer such high returns because the risk is greater. Like any investment, due diligence is a must and investors should consider bonds as one part of a well-diversified portfolio.