Muni Bond Funds: A Guide To Investing Wisely

Municipal bonds, or muni bonds, are debt securities issued by states, cities, counties, and other governmental entities to fund day-to-day operations and finance capital projects such as building schools, highways, or sewer systems. Muni bonds are generally exempt from federal taxes and, in many cases, state and local taxes as well. They are also considered low-risk investments with a very low historical default rate. However, it's important to note that municipal bonds generally offer lower interest rates than corporate bonds. There are two main types of municipal bonds: general obligation bonds and revenue bonds. When investing in muni bonds, individuals can choose to invest through the secondary market, new issues, bond funds, or a mutual fund or exchange-traded fund (ETF) that invests in bonds.

The benefits of investing in muni bond funds

Municipal bonds, or "munis", are debt securities issued by states, cities, counties, and other government entities. They are often considered a distinct asset class and are known for their tax advantages. Here are some benefits of investing in muni bond funds:

Tax Advantages

Municipal bonds offer several tax advantages over corporate bonds. The interest on most muni bonds is exempt from federal income tax, and some are also tax-free at the state and local levels. If you invest in a local municipal bond, it will typically be exempt from your state's income taxes as well. Muni bonds are particularly attractive for investors in high tax brackets as the tax exemption enhances the bond's return.

Low Default Risk

Municipal bonds also have a much lower rate of default compared to corporate bonds. According to Moody's, the annual municipal bond default rate was about 0.03% between 2009 and 2014, while the long-run corporate bond default rate is about 2.5% per year.

Safety and Low Volatility

Municipal bonds are considered a relatively safe and low-volatility investment. General obligation bonds, which are funded directly by tax revenues, are considered the safest type of municipal bond.

Infrastructure Development

Investing in muni bonds helps build infrastructure in your area. These bonds are used to finance public projects such as roads, bridges, schools, and other community developments.

Liquidity

Municipal bonds are also relatively liquid, providing investors with the ability to buy or sell them. However, investors need to be cautious of the bid-ask spread, which can substantially impact returns.

Diversification

Muni bonds can be used alongside other fixed-income securities such as Treasurys and corporate bonds to diversify an investment portfolio. They carry slightly more risk than Treasury bonds but are less risky than corporate bonds.

The risks of investing in muni bond funds

Municipal bonds, or "munis", are a relatively low-risk investment. However, as with any investment, there are risks involved.

Interest Rate Risk

As with any bond, there is an interest rate risk. If your money is tied up for a long period and interest rates rise, you will be stuck with a poor-performing bond that will lose value. This is especially true for investors in bond funds and exchange-traded funds (ETFs) that invest in munis. If Treasury yields increase, it is likely that muni bonds will follow suit. As a result, investors will see the principal value of their investment decline, even if default rates remain low.

Call Risk

Call risk refers to the potential for a bond issuer to repay a bond before its maturity date. This is more likely to happen if interest rates decline—much like a homeowner might refinance a mortgage to benefit from lower rates. Many municipal bonds are "callable", so investors who want to hold a muni bond until maturity should research the bond's call provisions before purchasing.

Credit Risk

Credit risk refers to the risk that the bond issuer may experience financial difficulties, making it challenging or impossible to pay interest and principal in full (the failure to do so is known as a "default"). Credit ratings are available for many bonds and can help investors assess the relative credit risk of a bond compared to others. However, it's important to note that a high rating does not guarantee that a bond will not default.

Inflation Risk

Inflation is a general upward movement in prices, reducing purchasing power. This poses a risk for investors receiving a fixed rate of interest, as inflation can lead to higher interest rates and, consequently, a lower market value for existing bonds.

Liquidity Risk

Liquidity risk refers to the possibility that investors won't find an active market for a municipal bond, potentially preventing them from buying or selling when desired and obtaining a certain price for the bond. Many investors buy municipal bonds to hold them rather than trade them, so the market for a particular bond may not be especially liquid, and quoted prices for the same bond may differ.

Tax Risks

Municipal bonds often offer tax advantages, with interest typically exempt from federal income taxes. If the bond is issued by the state in which the investor pays taxes, the interest may also be exempt from state and local taxes. However, there are some tax risks to be aware of. For example, if you invest in a municipal bond issued by a state other than your own, the interest earned may be subject to income tax, depending on the laws of your state. Additionally, the interest from a municipal bond may increase your Social Security taxes and can be considered part of the income that affects your monthly Medicare premiums.

Headline Risk

Municipal bonds face the risk of adverse headlines due to high-profile defaults. A forecast or news of slowing economic conditions or defaults among municipal issuers can scare investors and drive down the price of municipal bonds.

How to buy and sell muni bond funds

There are several ways to buy and sell muni bond funds. An investor can buy and sell bonds directly through an online brokerage account, or through a full-service brokerage or bank. Another option is to invest in an exchange-traded fund (ETF) or mutual fund that invests in municipal bonds.

When buying or selling bonds, it's important to remember that the price of a bond can be above or below its par value for many reasons, including changes in the credit rating of the issuer or the bond, supply and demand, and a host of other factors. However, the price is often driven by changing interest rates. If you sell a bond before it matures or buy a bond in the secondary market, you will most likely catch the bond between coupon payment dates. If you're selling, you're entitled to the price of the bond, plus accrued interest—the interest that adds up each day between coupon payments—up until the sale date.

The Municipal Securities Rulemaking Board's Electronic Municipal Market Access (EMMA) website is a good source of information on municipal securities. It provides free public access to municipal securities documents and data, such as official statements, financial disclosure documents, credit ratings information, trade prices, yields, and other data about a bond's trading history.

The tax implications of investing in muni bond funds

Municipal bonds, or "munis", are generally exempt from federal taxes and, in many cases, state and local taxes as well. However, there are some tax implications to be aware of before investing in muni bond funds.

Firstly, it is important to note that municipal bonds are not always entirely tax-free. While the interest income generated by municipal bonds is generally not subject to federal taxes, it may be taxable at the state or local level if the investor resides outside of the state in which the bond is issued. Therefore, it is crucial to check the tax implications of each specific municipal bond before adding it to your portfolio, as unexpected tax bills on any capital gains may occur.

Secondly, when buying munis on the secondary market, investors must consider the tax implications of capital gains. If a muni bond is purchased at a discount and then sold at a profit, the profit made will be subject to capital gains tax. This tax applies only to the principal of the bond and not to coupon payments. It is important to note that this tax treatment is different from that of most other investments, where capital losses can be used to offset capital gains. In the case of muni bonds, bonds purchased at a premium do not provide any capital losses to offset gains.

Thirdly, the de minimis tax rule is a complex concept related to muni bonds. If a bond is purchased at a discount, and the discount is equal to or greater than a quarter-point per year until maturity, the gain realised at redemption will be taxed as ordinary income rather than capital gains. This could result in a significantly higher tax rate being applied to the gain.

Fourthly, some muni bonds are subject to the alternative minimum tax (AMT). This is relatively uncommon, but it is important to consult a broker or tax professional before purchasing a specific muni bond to determine its tax status.

Lastly, when investing in muni bond funds through a mutual fund or exchange-traded fund (ETF), it is important to consider the tax treatment of any capital gains or losses generated by the fund manager through the buying and selling of securities within the fund. These gains or losses are typically distributed to investors once or twice a year and will affect the amount of tax owed.

In summary, while muni bond funds offer attractive tax advantages, it is important to carefully consider the specific tax implications of each investment before adding it to your portfolio. Consulting a tax professional can help to ensure that you are fully aware of any potential tax liabilities.

How to choose a muni bond fund

Municipal bonds, or "munis", are issued by state or local governments to fund their day-to-day operations or to finance capital projects such as building schools, roads, and bridges. They are generally exempt from federal income tax, and sometimes from state and local taxes, too.

There are two main ways to invest in municipal bonds: by purchasing individual bonds or by purchasing a fund. Here are some factors to consider when choosing a muni bond fund:

Diversification

Municipal bonds are considered a relatively safe investment, but they do carry some risk. To reduce this risk, it's important to diversify your investments across many different bonds and bond sectors. A mutual fund or exchange-traded fund (ETF) can be a good way to achieve diversification, as they offer exposure to a broad range of municipal bonds.

Management

When investing in a fund, you benefit from professional management. This means that a team of experts is responsible for researching and selecting the bonds that make up the fund, taking some of the burdens off the individual investor.

Trading costs

Trading costs can be prohibitive when purchasing individual bonds. By investing in a fund, you can benefit from lower trading costs, as the costs are shared among all investors in the fund.

Reinvestment

Mutual funds and ETFs offer the flexibility to reinvest proceeds at higher interest rates if interest rates are trending up.

Fees

When choosing a fund, it's important to consider the fees involved. Actively managed funds tend to have higher fees than passively managed funds, so it's worth comparing the fees charged by different fund managers before making a decision.

Risk and return

Different types of muni bond funds carry different levels of risk and potential returns. For example, high-yield muni funds have historically lost more value during market downturns than muni-national short-term funds. It's important to understand the risk profile of a fund before investing.

State-specific funds

If you live in a high-tax state, you may benefit from investing in a fund that focuses on bonds issued within your home state, as these can offer additional tax advantages. However, these funds also court a bit more credit risk due to their geographic focus.

Time horizon

Consider your investment time horizon when choosing a muni bond fund. If you plan to hold the investment for a shorter period, look for funds with lower interest-rate sensitivity and downside risk. If you're investing for the long term, you may be able to tolerate higher risk in exchange for potentially higher returns.

Account type

Finally, consider the type of account you're investing in. If you're investing in a tax-deferred account like a 401(k) or IRA, you may not need to invest in municipal bonds at all. Municipal bonds are most beneficial for those investing in taxable accounts, especially if they are in a higher tax bracket.

Frequently asked questions