- How Do Municipal Bonds Work?
- The Different Types Of Municipal Bonds
- How To Invest In Municipal Bonds
- The Challenges To Investing In Municipal Bonds
- Tips For Buying Municipal Bonds
- Wrapping Up: How To Invest In Municipal Bonds
You may have heard that municipal bonds are considered to be one of the safest securities. You may have also heard that they are an excellent way to add diversification to your portfolio. These tax-free bonds are attractive to many investors. However, with municipal bonds being high in demand but low in supply, it is getting harder to invest in them. The high demand for municipal bonds raises an important question.
How do you invest in municipal bonds? The way to invest in municipal bonds depends on whether you are a high-worth investor, your tolerance for risk, and your portfolio diversification needs. With that said, the three main ways you can invest in municipal bonds are through:
- The primary market
- The secondary market
- Mutual funds and exchange-traded funds
Before investing in municipal bonds, though, you will want to understand what they are and how they work as well as the types that exist. You will also want to understand the challenges that apply specifically to purchasing municipal bonds and tips to succeed in your investing efforts. Let’s get started!
How Do Municipal Bonds Work?
For those who have heard about municipal bonds (or muni bonds), but aren’t quite sure how they work, this is for you. Municipal bonds are state-, city-, county-, and district-backed bonds. These bonds are issued to back local projects that a state, city, county, or district is trying to fund. Municipal bonds are considered second in quality to US treasury bonds by many.
All municipal bonds are free of federal taxes on the interest you receive. You can also evade state taxes by purchasing a bond in your state of residence.
When you buy any bond, you agree to pay a certain amount of money, or the principal, over a specified period. The entity issuing the bond, in return, agrees to pay that investment back once that pre-determined period is up, or, in other words, when the bond matures. Before that, you, the investor, get interest payments twice a year during the timeframe in which you hold the bond.
For example, if you buy a 10-year $20,000 bond paying 3% interest, you will receive 3% on that $20,000 every six months until the ten years are up. Then, once the 10-year period is up, the issuer needs to return the original $20,000 back to you.
Typically, with corporate bonds, that interest you receive would be taxable. As stated previously, with municipal bonds, that is never the case at a federal tax level. If you buy at the state-level, your interest will also be exempt from state and local taxes. Bonds issued by US territories like Guam and Puerto Rico are triple-tax exempt as well.
The Different Types Of Municipal Bonds
Now that you know how municipal bonds work, you’ll also want to know what types exist to help you make a more informed investment decision. There are two kinds of municipal bonds: general obligation bonds and revenue bonds. Read on for more details about both.
General Obligation Bonds
General obligation bonds are issued to fund public projects to better communities without making revenue. Examples include building a park or improving school systems. When a general obligation bond is issued, the issuer must do everything it can to uphold the obligation to its bondholders. Typically that is done in the form of taxes. Hence, a city might raise taxes to cover the interest payments of its outstanding bonds.
Historically, general obligation bonds have been less likely to default (i.e., there is less likelihood of the issuer failing to fulfill the payment obligation) than revenue bonds and, therefore, are typically considered a safer investment.
Revenue bonds are issued to fund money-making projects. Revenue bonds are not backed by the full faith and credit of the municipality issuing them like with general obligation bonds. Instead, they are backed by the streams of income coming from the investment project.
An example of a project funded by revenue bonds would be the construction of a hospital. The hospital generates revenue, and that revenue is used to repay bondholders.
While revenue bonds do have higher default rates, that doesn’t mean that there aren’t revenue bonds worthy of investment. No matter what municipal bond you choose, you need to research to make the best investment decision.
How To Invest In Municipal Bonds
Now that you know how municipal bonds work and the different types, you’ll want to know how to invest in them. You can buy municipal bonds on the primary and secondary markets or through a mutual fund or exchange-traded fund.
Primary Bond Market
Using this method of buying municipal bonds is typically reserved for high net-worth investors. However, if you are a high net-worth investor, you can purchase new municipal bonds on the primary market. To do this, you need to create an account at a credited bond seller (e.g., a bank that underwrites the bond). Then, you have to work one on one with a representative from that institution to figure out the details (bond coupon, maturity date, and the number of bonds you want to buy) of the investment.
When you buy municipal bonds on the primary market, there are no pricing markups.
The secondary market allows you to buy bonds after they have already been issued. Typically, you would need to find a broker, investor, bond dealer, or bank who could find the bonds you want to and sell them to you. Since municipal bonds aren’t regulated the way that stocks are, you may have to pay a steep markup fee that includes commissions paid to the representative or firm finding the bonds for you.
However, municipal bond brokers need to register with the organization that governs the municipal bond market: the Municipal Securities Rulemaking Board. Therefore, they have to disclose pricing and markup information.
Also, noteworthy is that the secondary market quotes bond prices at $100, but the face value is usually $1,000 per bond.
An excellent resource for you to use is EMMA, which will tell you the historical trade prices for a particular bond so that you can make an informed decision before making a purchase.
Municipal Bonds, Mutual Funds, And Exchange-Traded Funds
If you go with a municipal bond mutual fund, an investing institution will research what municipal bonds to buy and include in the fund. All you have to do as the investor is purchase shares from the mutual fund through a brokerage firm (traditional or online) or directly from a mutual fund company.
Going with a mutual fund provides you with more diversification than buying individual bonds. This is because you would be buying a share in many different municipal bonds. With this method, if the issuer of one bond defaults, you won’t lose all of your money because you’ll be spreading your money out amongst various bonds instead of putting all of your money into one bond.
However, it is is more expensive due to the fund management fees.
Similar to mutual funds are exchange-traded funds (ETFs). A municipal bond ETF is also a collection of municipal bonds. In comparison to mutual funds, municipal bond ETFs typically have lower operating expenses and greater tax efficiency. Therefore, they usually charge much lower fees.
The Challenges To Investing In Municipal Bonds
Although adding municipal bonds to one’s portfolio is attractive to many, there are some challenges when it comes to purchasing these bonds. One of those challenges is that municipal bonds don’t trade on an exchange as stocks do. Instead, they are sold person to person, privately. Additionally, municipal bonds are in high demand but short supply, making it harder to get access to them.
Additionally, anything under $100K would be considered a small muni position. There is usually a minimum investment of $5,000 required to make a purchase. Because of this minimum requirement, municipal bonds are less accessible to the general public than corporate bonds and stocks.
Tips For Buying Municipal Bonds
When it comes to municipal bonds, there are a few main tips you should follow to have the highest chance of making a purchase and having success with your investment.
Below are the main tips you should consider when making a municipal bond purchase:
- Use brokerage firms like TD Ameritrade and Merril Edge that offer a wide variety of municipal bonds at low prices.
- Speak to a financial planner or utilize a Robo-adviser to help you make purchases that are best suited for your risk tolerance and long-term savings needs.
- Research the ratings of the bonds you plan to purchase. The three major rating agencies are Standard and Poor’s (S&P), Moody’s, and Fitch. These agencies rank issuers based on their likelihood of defaulting.
- Research what other investors recently paid for the bonds that you are looking to purchase. InvestinginBonds.com, MunicipalBonds.com, and the municipal bond site on Investor.gov are excellent resources for analyzing pricing.
- Buy directly from municipal bond owners. A useful website is MuniMarket.com, which matches buyers and sellers online that agree on a price before going through with a transaction.
- Research municipal bond individual prices, spreads, and bids on a state-by-state basis. You can still find municipal bonds at a discount.
Wrapping Up: How To Invest In Municipal Bonds
Now you know how to invest in municipal bonds. Due to their tax-free interest, low default rates in comparison to corporate bonds, and relative liquidity, municipal bonds are enticing to many investors looking for a safer investment and greater portfolio diversification.
However, investing in them can be a challenge and expensive. Make sure to always research the rating of a bond and the pricing before making a purchase. If you need help with deciding on what to invest in, speak to a financial adviser to help guide you. Additionally, If you’re looking to learn more about bonds, you may also enjoy our guide on how to invest in bonds.
Remember, you can also invest in mutual funds and exchange-traded funds instead of individual bonds to create even more diversification in your portfolio. The best part is that, by investing in municipal bonds, you also get to support a project meant to better local communities. Now, it’s time to build that portfolio!