What Are Municipal Bonds?

Read our Advertiser Disclosure.
Contributor, Benzinga
May 13, 2024

Municipal bonds, also known as munis, are essentially loans you make to local governments. Here's a quick rundown:

  • Issued by: States, cities, counties, and other government entities.
  • Purpose: Fund public projects like roads, schools, and hospitals.
  • How it works: You invest money and receive regular interest payments in return. You get your original investment back when the bond matures.
  • Tax advantage: Interest on munis is often exempt from federal and state taxes, making them attractive for certain investors.

Think of it as a way to support your community while potentially earning a tax-favored return.

Types of Municipal Bonds

There are two main types of municipal bonds: general obligation (GO) bonds and revenue bonds.

  • General Obligation Bonds: These bonds are backed by the full faith and credit of the issuing government entity. They are typically used to fund projects that benefit the whole community, such as schools or parks. General obligation bonds are considered very safe, as the government has the authority to levy taxes to repay bondholders if necessary.
  • Revenue Bonds: Unlike general obligation bonds, revenue bonds are backed by the revenue generated by the project that the bond is issued to finance. These projects can include toll roads, airports, water and sewer systems, and electric utilities. The repayment of revenue bonds is dependent on the success of the project and its ability to generate sufficient revenue. Investors who are considering revenue bonds should carefully analyze the financial viability of the project before investing.
  • Industrial Development Bonds: This type of bond is issued by a government entity on behalf of a private company to finance the construction or expansion of industrial facilities. Industrial development bonds are often used to attract new businesses to an area, create jobs, and stimulate economic growth. These bonds are backed by the private company's assets and are typically repaid by the company through lease payments or loan repayments.
  • Housing Bonds: As the name suggests, housing bonds are issued to fund affordable housing projects. These bonds help finance the construction, rehabilitation, or acquisition of housing facilities for low-income individuals or families. Housing bonds may also provide financing for mortgage loans or rental assistance programs. The repayment of housing bonds is usually secured by the rental income received from the housing projects.
  • Special Tax Bonds: Special tax bonds are backed by a specific tax or revenue source Special tax bonds are a type of municipal bond that is backed by a specific tax or revenue source. This means that the repayment of these bonds is tied directly to the revenue generated from a particular tax or fee.

How Do Municipal Bonds Work?

Like most bonds, municipal bonds make semi-annual interest payments, called a coupon. The coupon is paid until the municipal bond's maturity date. When a municipal bond matures, the investor receives their initial investment back. 

The main difference between municipal bonds and other bonds is the tax treatment on this interest income. For most municipal bonds, interest income is exempt from federal taxes. But if an investor sells a bond before maturity for a profit, the capital gain is still taxable. 

If an investor buys a municipal bond from the state they reside in, they may be exempt from state taxes as well. For example, an investor in California who buys a municipal bond issued by the California State Public Works Board can avoid paying state taxes on interest income. 

Municipal bonds come in two main types: general obligation and revenue bonds. 

  • General obligation bonds are unsecured. Their payments are not backed by revenue generated from a specific project. A good way to think of them is as a broad IOU an investor extends to a government for general purposes. These bonds have higher credit risk but can pay higher yields
  • Revenue bonds are secured. That is, their payments are linked to revenues generated by a specific project, such as tolls from a bridge or taxes from utilities. These bonds have lower credit risk but generally pay smaller yields. 

Like all bonds, municipal bonds possess duration, a measure of sensitivity to interest rate changes. When interest rates rise, existing municipal bonds see their prices drop, as their yields must increase until they are competitive with new issues. The opposite happens when interest rates fall. In this case, municipal bond yields fall, and their price rises. 

In general, the longer a municipal bond has until maturity, the greater its duration and sensitivity to interest rates. For example, all else being equal, a municipal bond with a duration of eight years will see its price fall by 8% if interest rates rise by 1%, and vice versa if rates fall by 1%. Durations can change based on many factors, so this is just a rule of thumb. 

An investor who sells a municipal bond before its maturity date could realize a loss or gain on its selling price depending on how interest rates trend. If the municipal bond is held until maturity, the full principal investment is returned, and the interest rate risk is mitigated. A good practice here is buying municipal bonds with maturities matching the date you need to use the money by. 

Finally, like all bonds, municipal bonds have default risk. This is the chance that the issuing entity fails to make either coupon or principal payments on time or in full. While federal government bonds like U.S. Treasurys are virtually risk-free in terms of default, state, county and municipal governments have defaulted in the past. 

For example, Arkansas defaulted on its highway bonds in 1933. For municipal bond investors, a default can cause a sharp drop in the price of their holdings. So municipal bond investors should carefully assess a municipal bond's credit rating before buying. A general rule is that as yields increase, credit ratings decrease, so there is a trade-off. 

Why Invest in Municipal Bonds?

Municipal bonds can be a great way of diversifying a fixed-income allocation beyond just Treasurys and corporate bonds. Here are some reasons an investor may choose to invest in municipal bonds:

  • Tax efficiency: As noted earlier, interest income from municipal bonds is exempt from federal taxes and can be exempt from state taxation depending on the investor's residency. 
  • Lower risk: Compared to corporate bonds, municipal bonds tend to have higher credit ratings, which generally range in the A, AA or AAA rating categories from Standard & Poors (S&P). 
  • Accessibility: Municipal bonds can be purchased individually or via a mutual fund / exchange-traded fund (ETF) using most online brokerages. 

Who Should Invest in Municipal Bonds?

Various retail and institutional investors invest in municipal bonds. Generally, the profile of these investors is someone who has a long investment horizon, possesses a low- to medium-risk tolerance, has defined income needs and prioritizes tax efficiency. Examples could include:

  • Retirees: Retirees withdrawing from taxable accounts can use municipal bonds as their safer fixed-income allocation for lowered volatility and improved tax efficiency. For example, a retiree with a conservative 40/60 portfolio of stocks and bonds could have municipal bonds comprise the entirety of their bond allocation. 
  • Pension funds: Pension funds are often charged with investing conservatively and with a goal of producing good risk-adjusted returns. The lower volatility and high credit quality of municipal bonds can help them meet these goals. Better tax efficiency can also help them improve net returns. 
  • Insurance companies: Insurance companies often hold large fixed-income reserves to meet payouts. The higher credit quality of municipal bonds can help them lower risk in their fixed-income allocations while still targeting attractive yields and tax efficiency. 

Compare Municipal Bond Brokers

Municipal bonds can be researched and compared via various platforms. Investors looking for further insights and reviews of bonds can use Benzinga to compare the available options for buying municipal bonds. Here is a list of brokers that support municipal bond purchases. 

Frequently Asked Questions

Q

Are municipal bonds a good investment?

A

Whether municipal bonds are a good investment depends on the particular investor’s objectives, risk tolerance and time horizon. Municipal bonds may be good investments for high-income-bracket investors using a taxable brokerage account. In this case, holding Treasury or corporate bonds can incur higher tax drags. By substituting a portion or all of their bond allocation with municipal bonds, these investors can realize higher after-tax returns without significantly increasing their risk.  

Q

What is an example of a municipal bond?

A

A real-life example of a municipal bond is a general obligation bond that will be issued by the California Infrastructure and Economic Development Bank in January for its Clean Water State Revolving Fund. The total offering amount will be $500 million. An example of a municipal bond exchange-traded fund, or ETF, is the iShares National Muni Bond ETF (NYSEARCA: MUB), which holds roughly 5,500 different municipal bonds from various issuers. 

Q

What is the downside of municipal bonds?

A

Municipal bonds offer tax-free income, but have lower returns than some investments. They’re also sensitive to rising interest rates and inflation, and there’s a slight risk of default by the issuer.

About Tony Dong

Tony Dong, MSc, CETF®, is a seasoned investment writer and financial analyst with a wealth of expertise in ETF and mutual fund analysis. With a background in risk management, Tony graduated from Columbia University in 2023, showcasing his commitment to continuous learning and professional development. His insightful contributions have been featured in reputable publications such as U.S. News & World Report, USA Today, Benzinga, The Motley Fool, and TheStreet. Tony’s dedication to providing valuable insights into the world of investing has earned him recognition as a trusted source in the finance industry. Through his writing, he aims to empower investors with the knowledge and tools needed to make informed financial decisions.