Municipal bonds have earned their reputation as among the safest securities available. They also provide excellent portfolio diversification opportunities. These tax-free bonds attract many investors for good reason. However, with strong demand but limited supply, accessing municipal bonds has become increasingly challenging. This high-demand environment raises a crucial question.
How do you invest in municipal bonds? Your investment approach will depend on your net worth status, risk tolerance, and diversification objectives. That said, you can invest in municipal bonds through three main channels:
- The primary market
- The secondary market
- Mutual funds and exchange-traded funds
Before diving into municipal bond investing, you’ll need to grasp what these securities are and how they function, plus the various types available. Understanding the specific challenges of purchasing municipal bonds—along with strategies for successful investing—is equally important. Let’s explore these essentials!
How Do Municipal Bonds Work?
If you’ve heard about municipal bonds (or muni bonds) but aren’t quite sure how they operate, here’s what you need to know. Municipal bonds are debt securities backed by state, city, county, and district governments. These bonds fund local projects that governmental entities need to finance. Many consider municipal bonds second only to US treasury bonds in terms of quality.
All municipal bonds offer federal tax exemption on interest payments. You can also avoid state taxes by purchasing bonds issued within your state of residence.
When you purchase any bond, you provide a specific amount of money (the principal) for a predetermined period. In return, the bond issuer commits to repaying that investment when the specified period ends—when the bond matures. Throughout the holding period, you receive biannual interest payments as the bondholder.
For example, purchasing a 10-year $20,000 bond paying 3% interest means you’ll receive 3% on that $20,000 every six months until maturity. After ten years, the issuer must return your original $20,000 investment.
With corporate bonds, interest payments are typically taxable income. Municipal bonds differ significantly—interest is never taxed at the federal level. State-level purchases provide additional benefits, as your interest becomes exempt from state and local taxes as well. Bonds from US territories like Guam and Puerto Rico offer triple-tax exemption.
The Different Types Of Municipal Bonds
Understanding how municipal bonds work is just the beginning—knowing the available types helps you make informed investment decisions. Municipal bonds fall into two categories: general obligation bonds and revenue bonds. Here’s what distinguishes each type.
General Obligation Bonds
General obligation bonds finance public projects that benefit communities without generating revenue—think parks or school system improvements. When issuing these bonds, the entity must exhaust all resources to meet its obligations to bondholders. This typically involves raising taxes, so a city might increase tax rates to cover interest payments on outstanding bonds.
General obligation bonds have historically shown lower default rates than revenue bonds (meaning less risk of payment failure), making them typically safer investments.
Revenue Bonds
Revenue bonds finance revenue-generating projects. Unlike general obligation bonds, these aren’t backed by the municipality’s full faith and credit. Instead, they rely on income streams from the specific funded project.
Hospital construction exemplifies a revenue bond project. The completed hospital generates revenue, which then repays bondholders.
Despite higher default rates, many revenue bonds still merit investment consideration. Regardless of which municipal bond type you choose, thorough research remains essential for optimal investment decisions.
How To Invest In Municipal Bonds
With a solid understanding of municipal bond fundamentals and types, let’s explore your investment options. You can purchase municipal bonds through primary and secondary markets, or via mutual funds and exchange-traded funds.
Primary Bond Market
Primary market purchasing is generally reserved for high net-worth investors. If you qualify, you can buy newly issued municipal bonds directly from the source. This requires establishing an account with a credited bond seller (such as an underwriting bank), then collaborating with their representative to determine investment specifics: bond coupon, maturity date, and quantity desired.
Primary market purchases come without pricing markups—a significant advantage.
Secondary Market
The secondary market enables purchasing previously issued bonds. You’ll need to work with a broker, investor, bond dealer, or bank to locate and purchase your desired bonds. Since municipal bonds lack stock-like regulation, you may face substantial markup fees that include commissions for the representative or firm securing your bonds.
Municipal bond brokers must register with the Municipal Securities Rulemaking Board—the industry’s governing organization. This requirement mandates disclosure of pricing and markup information.
Note that secondary market quotes show bond prices at $100, though face value typically equals $1,000 per bond.
EMMA serves as an invaluable resource, providing historical trade prices for specific bonds to inform your purchasing decisions.
Municipal Bonds, Mutual Funds, And Exchange-Traded Funds
Municipal bond mutual funds involve professional institutions researching and selecting bonds for the fund’s portfolio. As an investor, you simply purchase fund shares through brokerage firms (traditional or online) or directly from mutual fund companies.
Choosing a mutual fund delivers greater diversification than individual bond purchases. You’re buying shares in numerous municipal bonds, so if one issuer defaults, you won’t lose everything—your investment spreads across various bonds rather than concentrating in one.
The trade-off is higher costs due to fund management fees.
Exchange-traded funds (ETFs) function similarly to mutual funds—they’re collections of municipal bonds. Compared to mutual funds, municipal bond ETFs typically offer lower operating expenses and superior tax efficiency, resulting in significantly reduced fees.
The Challenges To Investing In Municipal Bonds
While municipal bonds appeal to many portfolio builders, purchasing these securities presents unique challenges. Unlike stocks, municipal bonds don’t trade on exchanges—they’re sold privately between individuals. Combined with high demand but short supply, accessing these bonds becomes increasingly difficult.
Position sizes under $100K are considered small in the municipal bond world. Most purchases require minimum investments of $5,000. This threshold makes municipal bonds less accessible to general investors compared to corporate bonds and stocks.
Tips For Buying Municipal Bonds
Several key strategies can maximize your chances of successful municipal bond purchases and investment outcomes.
Consider these essential tips when purchasing municipal bonds:
- Choose brokerage firms like TD Ameritrade and Merril Edge that provide extensive municipal bond selections at competitive prices.
- Consult financial planners or utilize robo-advisers to align purchases with your risk tolerance and long-term financial goals.
- Investigate ratings for bonds you’re considering. Standard and Poor’s (S&P), Moody’s, and Fitch—the three major agencies—rank issuers based on default probability.
- Research recent prices paid by other investors for your target bonds. InvestinginBonds.com, MunicipalBonds.com, and the municipal bond section on Investor.gov provide excellent pricing analysis tools.
- Purchase directly from municipal bond owners. MuniMarket.com connects buyers and sellers online, allowing price agreement before transaction completion.
- Analyze municipal bond pricing, spreads, and bids on a state-by-state basis. Discounted municipal bonds are still discoverable with proper research.
Wrapping Up: How To Invest In Municipal Bonds
You now understand how to invest in municipal bonds effectively. Their tax-free interest, lower default rates compared to corporate bonds, and relative liquidity make them attractive to investors seeking safer investments and enhanced portfolio diversification.
Investment challenges and costs are real considerations, though. Always research bond ratings and pricing before purchasing. When you need guidance on investment selection, consult financial advisers for professional direction. If you want to expand your bond knowledge further, explore our comprehensive guide on how to invest in bonds.
Consider mutual funds and exchange-traded funds as alternatives to individual bonds for enhanced portfolio diversification. An added benefit of municipal bond investing is supporting projects designed to improve local communities. Now it’s time to start building that portfolio!
