Introduction to Municipal Bonds

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Municipal bonds (munis) are bonds issued by states or municipalities to fund general government spending or finance specific projects, such as bridges or sewers. The interest on municipal bonds is tax-free on the federal level, and is usually exempt from state taxes for those who live in the states in which the bonds are issued. When interest is tax-exempt on both the federal level, it is said to be “double tax-free.”

Are Munis Right for You?

Although the idea of a tax-free bond may sound great at first, the primary benefit of tax exemption is accrued by those in the highest tax brackets. Investors in lower tax brackets may, in fact, be better off in taxable bonds since they tend to pay higher pre-tax yields than municipal bonds. In other words, for those in lower brackets, the tax benefit of munis may not be large enough to offset the bonds' lower yields.

The easy way to determine which is the better course of action is to calculate the tax-equivalent yield (TEY) of a particular bond via this simple two step process:

First, find the reciprocal of your tax rate using the equation 1 – your tax rate. If you pay 28%, the reciprocal is simply 1 - .28, or .72 (72%).

Second, divide this into the yield on the tax-free bond to find out the tax-equivalent yield. If the bond in question is yielding 4%, the equation is: 4.0 divided by .72, or 5.56%.

You can learn more about this process, as well some specific considerations to keep in mind when comparing taxable and tax-exempt securities, in my article How to Calculate Tax Equivalent Yield.

Munis and IRAs Aren’t a Good Mix

When determining if munis are right for you, it’s also important to consider the type of account you’ll be using to invest.

Those who use a taxable account will gain the full benefit of munis’ tax exemption. However, using a tax-deferred account such as an IRA or 401(k) doesn’t make sense because interest income in such accounts is already tax-exempt. There’s no rule against investing in munis in a tax-deferred account, but if an investor has a choice between that or investing via a taxable account, the latter course makes more sense.

The Returns and Risks of Municipal Bonds

In any given year, municipal bonds tend to deliver returns that are similar in direction to those of the broader investment-grade bond market, although not necessarily in magnitude. This chart shows the returns of the Barclays Municipal Bond Index in each calendar year from 1991 through 2013. Munis have delivered positive total returns in 19 of the past 23 calendar years, with a high of 17.46% (1995), a low of -5.17% (1994), and an average calendar-year return of about 6%.

The performance of municipal bonds is driven by three key factors:

  • Interest rate risk: This is the risk that broader bond-market fluctuations will impact performance in the municipal bond market. When yields on U.S. Treasuries are falling, as they did in the 2009-2012 interval, it helps create a positive backdrop for munis. (Keep in mind, prices and yields move in opposite directions). At the same time, periods of rising Treasury yields – such as 2013, when the Barclays Municipal Bond Index returned -2.55% – create headwinds for municipal bonds.
  • Credit risk: Credit risk is the way the shifting risk for the potential default by an issuer can affect its bonds' performance. For instance, a municipality that is seeing stronger tax revenues should see a positive impact on its price, while one that appears to be in increasing financial peril will be affected negatively.

    Credit risk also incorporates the impact that broader economic conditions can have on the general creditworthiness of municipal bond issuers. For instance, when the economy and housing market are strong, investors typically gain more confidence with regard to the underlying financial strength of municipal issuers. Conversely, a recession reduces confidence and causes investors to demand higher yields (and lower prices). This is visible in municipal bonds -2.48% return of 2008. Even though Treasury yields fell and investment-grade bonds returned nearly 5.5%, municipal bonds lost ground due to concerns about the broader impact of that year’s financial crisis.
  • Headline risk: Municipal bonds are also affected by headline risk, or the risk that news items will cause investors to lose confidence. Examples include not just the financial crisis of 2008, but also the Orange County bankruptcy of 1994, Meredith Whitney’s prediction of “a wave” of municipal defaults in 2010. Typically, however, sell-offs related to headline risk have proven to be compelling buying opportunities rather than a reason to panic.

These considerations are discussed in greater detail in the article “The Risks of Municipal Bonds.”

How to Invest in Municipal Bonds

Investors generally choose among three options for investing in municipal bonds: individual securities, mutual funds, exchange-traded funds (ETFs), or closed-end funds.

Investing in individual securities can be challenging for many individuals. While this approach presents the opportunity to find specific investments with an attractive trade-off of risk and return, this process can also be difficult for those without specific knowledge of credit analysis. The danger here is that someone will simply choose a bond based on its yield, rather than digging deeper to find out why its yield may be above-average. On the plus side, investing in individual bonds and holding them to maturity helps mitigate the impact of the interest-rate risk and headline risk described above.

Most beginning to intermediate investors choose to invest in municipal bonds via mutual funds or ETFs. These products provide the combination of professional management and a diversified portfolio that can be accessed via a single investment. However, the vast majority of funds have no specific maturity date. This means that factors such as interest-rate risk can cause the price to fall and stay low for an extended period, potentially forcing the investor to lock in the loss if he or she needs to sell the fund.

Investors, therefore, need to be sure that they can buy and hold a municipal bond fund for at least three years before buying. Additionally, municipal bond funds – while safer than, say, high-yield bond funds, emerging market bonds, or stocks – aren't an appropriate investment for someone with a short-term investment horizon or for whom safety of principal is the top priority.

Morningstar’s list of municipal bond funds can be found here, and you can read a review of the various municipal bond ETFs here.

High Yield Vs. Investment Grade

While the phrase “high yield bonds” is typically associated with corporate debt, investors can also invest in high yield municipal bonds. Like high yield corporates, high yield munis tend to have higher credit risk (or a higher risk of default), but they also offer higher yields. Investors who have a longer time horizon and who can tolerate more risk can use high-yield munis as a way to boost their after tax-income. Learn more about this unheralded market segment.

Types of Municipal Bonds

Municipal bonds come in a variety of flavors, as outlined in the list below. If you would like more information, the links at the end of this section provide more detail on each type of bond.

  • General Obligation Bonds: Also called GOs, these are bonds that are backed by the “full faith and credit” of the issuer, with no specific project identified as the source of funds.
  • Revenue Bonds: Bonds that are backed by the revenue generated by the specific project being financed by the bond issue.
  • Anticipation Notes: A bond issued by an entity that needs to fulfill a short-term cash need. Once the entity receives the cash it is “anticipating,” it uses these funds to pay off the securities at maturity.
  • Pre-Refunded Municipal Bonds: A bond that the issuer redeems, or “calls,” from bondholders prior to the maturity date. When interest rates are falling, issuers can “call” the bonds that they issued at higher rates in order to reduce their interest expense. Once the issuer sells the new (lower-yielding) bond, it will use the proceeds to buy Treasury securities that mature at or near the same time as the original issue. The interest from the Treasury issue pays the interest on the pre-refunded bond until it matures, while the principal from the maturing Treasury pays off the principal.
  • Insured Municipal Bonds: Insured municipal bonds are bond issues that carry private insurance that guarantees the bond’s principal and interest will be paid in the event that the issuer cannot do so.
  • Build America Bonds: Also known as “BABs,” these are municipal bonds issued from April 2009, through December 2010, as part of the American Recovery and Reinvestment Act. Unlike traditional munis, the income is fully taxable to investors.
  • Green Bonds: A bond whose proceeds are used to fund environment-friendly projects. Many bond issues devote a portion of the proceeds to such causes, but green bonds are those specifically designated for the environment.
