Takeaways
- Municipal bonds, or “Munis,” are debt securities issued by state, county, or city governments.
- Municipal bonds finance both day-to-day operations and major capital projects.
- Investors like municipal bonds for their tax-advantaged interest payments.
- Municipal bonds typically pay bondholders interest annually or semi-annually.
- Short-term municipal bonds have 1 – 3-year terms, while some long-term bonds have terms lasting over a decade.
What Are Municipal Bonds?
Municipal bonds are a specific type of debt security that city, state, and local governments issue to fund day-to-day operations and public projects.[1] When you buy a municipal bond, you effectively lend the government money in return for regular interest payments, known as coupon payments.
You can purchase short-term or long-term bonds. At the end of the bond’s term, the government repays the face value, or principal, of the bond.
Munis are incredibly attractive to institutional and retail investors because the interest earned is often exempt from federal income taxes (and even state taxes if you live where the bond is issued). Municipal bonds are a reliable way for city, county, and state governments to raise capital for infrastructure development, community projects, and costs in running local governments.
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How a Municipal Bond Works
Municipal bonds function just like most other types of bonds. You loan money to the bond issuer, and in return, they pay periodic interest payments and return the principal once the bond has reached maturity. Municipal bonds are issued with set terms, determining the coupon or interest rate and the time it will take to mature.
There are only two common municipal bonds: general obligation and revenue bonds.
- General obligation bonds have the backing of the full faith and credit of the municipality that issues them, meaning they are supported by tax revenue.
- Revenue bonds, on the other hand, are repaid with the income generated from the specific project receiving bond funding. Examples include toll roads or public utilities.
Interest rates can be fixed or variable, depending on the municipal bond. Muni bonds have terms ranging from one year to bonds that mature over several decades. Investors receive interest payments at regular intervals (usually semi-annually) until the bond matures.
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What Do Municipal Bonds Fund?
Municipal bonds are generally used to fund public projects that have the potential to benefit the entire community. Some examples of municipal bond-funded projects include:
- Bridges
- Roads
- Public Schools
- Hospitals
- Public Transportation Systems
The revenue generated from bond sales also has the potential to support ongoing essential services like:
- Fire Departments
- Public Libraries
- Parks and Recreation Centers
General obligation bonds are typically used for broader public projects that do not usually generate income directly. Revenue bonds, in contrast, are linked to specific projects that create the revenue for repayment.
Both general and revenue bond structures allow government entities to invest in long-term projects that support the maintenance and development of countless public resources.
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5 Steps to Buy Municipal Bonds
If you want to invest in municipal bonds, the easiest way is through your online brokerage account. Here are five steps to get you started:
1. Set Up a Brokerage Account: The most common way is through an online brokerage firm. You can also make bond purchases through this platform if you already have a stock brokerage account. (Read more about the best online brokerage accounts).
2. Research Bonds: Before buying a municipal bond, thoroughly research its credit rating. Bond credit ratings are made by well-known agencies like Standard & Poor’s or Moody’s. These agencies assess the overall financial health of the issuing entity and the likelihood that it will repay the bond as agreed. Bonds with higher credit ratings usually offer lower yields because you take less risk. However, lower-rated bonds offer high-interest payments because the investor assumes more risk.
3. Decide General vs. Revenue: One of the most significant differences in bond investments is knowing what the bond is funding. You should decide if investing in a general bond backed by the municipality or a revenue bond supported by revenue generated from a project is right for you. Consider your risk appetite and where you want this fixed-income investment to set with your overall portfolio.
4. Determine Investment Size: You must determine how much of your available portfolio you want to invest in munis. There are other bonds (corporate, green, agency) that you can invest in as well. Whether you choose a specific dollar amount or percentage allocation, you must determine the best investment amount. More conservative investors and others nearing retirement tend to favor municipal bonds. (Read about how to retire 10 years early).
5. Choose Bonds or Bond Funds: Many investors buy municipal bonds through managed funds, like bond mutual funds or bond ETFs specializing in these securities. Bond funds allow you to invest in a diversified portfolio rather than just one single bond. The result is a significant reduction in investment risk because you spread your investment into multiple bonds instead of a single issuer.
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Pros of Municipal Bonds
- Tax-advantaged investments can be a significant win for your portfolio. A unique benefit of municipal bonds is the tax exemption on interest income. In most cases, the interest earned from municipal bonds is not taxed federally, and bonds issued within the state may also be exempt from state and local taxes. (Read about your tax bracket and rates).
- Safe Investments allow you to titrate your portfolio between conservative and hyper-aggressive Investments (e.g., cryptocurrencies). Municipal bonds, particularly general obligation bonds, are relatively safe investments. These bonds have government backing and are repaid from taxes, making them exceptionally low-risk investments.
- Interest Income based on coupon payments is extremely attractive to fixed-income investors, retirees, and investors building a passive income. Muni bonds provide a steady stream of income payments that give institutional and retail investors the income they need to meet their financial goals.
- Low credit risk is another advantage of municipal bonds. Credit risk, or the risk of defaults on interest or principal payments, is very low for this type of bond. This allows sophisticated investors to calibrate their investment portfolio with this risk profile in mind. (Read about the right times to talk to a financial advisor).
Cons of Municipal Bonds
While they have some notable benefits, municipal bonds also have potential downsides:
- Low Yields are one of the most significant drawbacks to investing in municipal bonds. These bonds return a relatively low yield compared to other marketable securities and high-yield investments. (Read about 9 low-risk investments).
- Call Risk is the risk that a municipality that issued a municipal bond will repay a bond before a bond’s maturity date. While this is rare, it would decrease your overall return on the municipal bond, and you would not reap the reward of as much tax-free interest income.
- Credit Risk is the risk that a municipality will default on its bond interest or principal payments. Defaults in municipal bonds don’t happen often (which is why it was also listed as a pro), but they should be a part of your investment calculus. (Read more about credit risk).
- Inflation Risk is the gradual or sudden increase in prices over time. For example, investors holding muni bonds with a fixed interest rate of 4% will lose money if inflation rises above 4%. Investors will ditch municipal bonds, and funds will flow to higher-yielding assets. For example, investors could purchase stocks or stash their cash in a high-yield online savings account.
Municipal Bond Example
A local county wants to build a public library but needs more funds. To fund the construction, the county can issue a general obligation bond. The country issues $10,000,000 worth of bonds to investors.
You purchase $10,000 in this 10-year municipal bond, paying a 4% fixed interest rate. The bond pays coupon payments semi-annually. You will earn roughly $400 annual interest income. The interest income you earn from this municipal bond is also tax-advantaged in your state, city, and county, reducing your annual tax bill and juicing your investment return.
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Smart Summary
Municipal bonds are issued by state, county, and city governments to fund day-to-day operations, capital projects, and ongoing programs. Investors favor muni bonds for their regular, consistent, and predictable coupon payments, which are a draw for fixed-income investors. Additionally, their interest payments are tax-advantaged, and investors usually don’t have to pay federal income on interest income or state and local tax if they live where the bonds are issued. (Read more about the different types of bonds).
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(1) Securities and Exchange Commission. What are Municipal Bonds? Last Accessed January 12, 2025.
