Muni Bond Funds: Smart Investment Or Risky Business?

Municipal bonds, or muni bonds, are debt instruments issued by cities, counties, states, and other municipal authorities to raise funds for public projects. They are considered a relatively safe investment option due to their low default risk and tax advantages. Muni bonds offer tax-free interest income, which can be beneficial for high-income individuals in states with high income taxes. However, it's important to consider the potential drawbacks, such as lower interest rates compared to corporate bonds and the possibility of capital losses when interest rates rise. Before investing, individuals should assess their financial goals, tax brackets, and the credit ratings of the issuing municipalities.

Municipal bond funds vs. individual bonds

Municipal bonds are debt instruments that city and local governments use to raise money for public projects. They are often referred to as "munis" and offer unique tax advantages that can offset their modest returns, all with relatively low risk.

Municipal bond funds, such as exchange-traded funds (ETFs) and mutual funds, can be an attractive option for investors looking to benefit from the advantages of municipal bonds while reducing their risk exposure.

Control and Transparency:

Investing in individual bonds provides greater control and transparency over your portfolio. You decide what to buy and whether to hold the bonds until maturity or sell them beforehand. You also have access to detailed information about your holdings at any time. However, this increased control comes with the responsibility of managing your portfolio, which requires significant research and ongoing monitoring.

On the other hand, bond funds, such as ETFs and mutual funds, offer less control over the specific holdings but provide a more hands-off approach. While you choose the fund that aligns with your investment goals, a professional manages the pool of money and makes investment decisions within the fund's stated objectives and guardrails.

Research and Oversight:

Investing in individual bonds requires extensive research and oversight. You need to research and monitor the financial stability of each issuer, determine the reasonableness of bond prices, and build a portfolio that aligns with your income needs, risk tolerance, and diversification goals. In contrast, bond funds reduce the level of research and oversight required, as you primarily need to compare available funds and track their performance.

Credit Risk:

Both individual bonds and bond funds carry credit risk, which is the risk that a bond issuer will not make its scheduled payments. The quality of the bonds in your portfolio determines the overall credit risk. While diversification can help mitigate this risk, it is more cumbersome to achieve with individual bonds. Bond funds, particularly those focused on high-yield or below-investment-grade issuers, may carry higher credit risk but also offer broader diversification.

Minimum Investment and Liquidity:

Individual bonds typically require a higher minimum investment compared to bond funds. Diversifying your portfolio across various individual bonds can be costly. In contrast, bond funds allow you to build a diversified portfolio with a lower initial investment since they are often broadly diversified across many issuers.

Individual bonds provide liquidity through coupon payments and maturity. However, if you need to access your principal before maturity, you may incur transaction fees, and certain types of bonds may be easier to sell than others. Mutual funds offer daily liquidity, while ETFs provide intraday liquidity, allowing you to buy or sell shares during regular market trading hours.

Impact of Interest Rate Changes:

When interest rates rise, the market value of individual bonds generally falls, and when rates fall, bond prices rise. Investors holding individual bonds to maturity may not realize this impact. In contrast, investors in bond funds will see volatility in their holdings' value due to interest rate changes, potentially resulting in a gain or loss when they redeem their shares.

Both individual municipal bonds and municipal bond funds have their advantages and considerations. Individual bonds offer greater control and transparency but require more time and financial resources. On the other hand, bond funds provide broader diversification, reduced default risk, and lower minimum investment amounts but offer less control over specific holdings. Ultimately, the right choice depends on your investment goals, the amount of money you have to invest, your ability to research and monitor your investments, and your tolerance for different types of risk.

Tax advantages and disadvantages

Municipal bonds, or muni bonds, are a good way to preserve capital while generating interest. They are also a good way to support infrastructure projects in your area. Muni bonds are backed by states, cities, counties, and other municipal authorities, and they yield steady returns with lower default rates.

Tax Advantages:

Muni bonds have several tax advantages over corporate bonds. The interest on muni bonds is usually tax-free at the federal level, and sometimes at the state and local levels as well, especially if the bond is issued in your locality. This triple exemption can be a great tax break for those living in high-tax states.

Muni bonds are also often exempt from alternative minimum tax (AMT). The tax benefits of muni bonds are most advantageous for those in higher tax brackets, as rates usually increase with income. So, higher-income individuals benefit more from the tax exemptions of muni bonds.

Tax Disadvantages:

Muni bonds are not completely free from taxes. You may still have to pay state and local taxes, depending on where you reside and where the bond was issued. If you buy a muni bond on the secondary market at a discount, the IRS may charge you capital gains tax when you sell it for a profit or it reaches maturity. In some cases, you may have to pay taxes at your regular income tax rate due to the de minimis tax rule.

If you receive Social Security, your muni bond interest will be counted as income when calculating the taxable amount of your Social Security income, which could increase the amount you owe.

Default risk

Municipal bonds are debt instruments issued by city and local governments to raise money for public projects such as infrastructure development. These bonds typically carry lower interest rates compared to corporate bonds. One of the main advantages of municipal bonds is their low default risk. From 1970 to 2019, the 10-year cumulative default rate for all rated municipal bonds was just 0.2%, according to T. Rowe Price. In comparison, the corporate bond default rate during the same period was significantly higher at 10.2%.

However, it is important to remember that default risk is not non-existent in municipal bonds. There have been instances where governments have defaulted on their municipal bonds, such as Detroit in 2013 and Puerto Rico in 2016. The higher the yield offered by a municipal bond, the higher its risk of default. Therefore, it is crucial to assess the credit rating of the issuing municipality before investing.

There are two main types of municipal bonds: general obligation bonds and revenue bonds. General obligation bonds are backed by the "full faith and credit" of the issuing municipality and are considered the most secure type of bond. They have the lowest interest rates among municipal bonds. Revenue bonds, on the other hand, are repaid using specified future income streams, such as utility bills or payments from customers. If the local government fails to collect the expected revenue, there is a risk of default on these bonds.

To mitigate default risk, investors can consider investing in municipal bond funds, such as exchange-traded funds (ETFs) or mutual funds. These funds provide instant diversification by investing in multiple municipalities, reducing the impact of a single default. Additionally, municipal bond ETFs have well-balanced portfolios, typically limiting the exposure to any single municipal bond to 2% or less of the total assets.

In summary, while municipal bonds have a significantly lower default risk compared to corporate bonds, it is important to remember that default risk still exists. Investors should carefully assess the credit rating of the issuing municipality and consider diversifying their investments through municipal bond funds to minimise the impact of potential defaults.

Municipal bond ratings

Municipal bonds are debt instruments that city and local governments borrow to raise money for public projects such as schools, streets, highways, bridges, hospitals, public housing, and utilities. These "muni" bonds come with unique tax advantages, including no federal income taxes on interest payments, and often no state or local income taxes either.

Before investing in municipal bonds, it is important to check their credit rating, as assessed by a neutral third party. The credit rating showcases the credit quality and credit risk of each municipal bond. There are three major rating agencies for municipal bonds: Moody's Investors Service, S&P Global (formerly Standard & Poor's), and Fitch Ratings. Of these three, S&P Global and Moody's rate over 80% of all municipal and corporate bonds.

When assigning a rating for general obligation bonds, the rating agencies assess the following factors:

• Financial Condition
• Demographic Factors
• Management practices of the governing body and administration

The above criteria are also used to analyse revenue bonds and lease obligations, although additional credit criteria are considered, such as users and user charges for utilities. Rating agencies use mathematical ratios to compare an issuer to others, but a rating is not a scientific evaluation, and subjective evaluation also plays a role in the final rating assigned.

Moody's Ratings:

• Aaa – Issuers or issues rated Aaa demonstrate the strongest creditworthiness relative to other U.S. municipal or tax-exempt issuers or issues.
• Aa – Issuers or issues rated Aa demonstrate very strong creditworthiness relative to other U.S. municipal or tax-exempt issuers or issues.
• A – Issuers or issues rated A present above-average creditworthiness relative to other U.S. municipal or tax-exempt issuers or issues.
• Baa – Issuers or issues rated Baa represent average creditworthiness relative to other U.S. municipal or tax-exempt issuers or issues.

Bonds in the Aa, A, and Baa categories are also assigned a number (1, 2, or 3) based on their strength within each category. For example, A1 is stronger than A2, and so on.

S&P Global Ratings:

S&P's ratings are similar to Moody's, except that all letters are capitalised, and ratings within a category are assigned a "+" for the strongest credits and a "-" for the weakest. For example, A+ is better than A, and A- is the weakest credit within the A category.

It is important to remember that ratings are not a perfect indicator of a bond's performance and should not be the sole factor in your investment decision-making process. They are, however, often the single most important factor affecting the interest cost on bonds.

Municipal bonds for high-income individuals

Municipal bonds are a type of debt security issued by local, county, and state governments. They are often used to finance community projects, such as the construction of schools, hospitals, highways, bridges, parks, libraries, and other infrastructure. These bonds are commonly referred to as "munis" and act as loans, with bondholders becoming creditors.

For high-income individuals, municipal bonds can be an attractive investment option due to their tax advantages. The interest paid on municipal bonds is often exempt from federal income taxes, and sometimes from state and local income taxes as well, making them particularly appealing to those in higher tax brackets. This tax-free status can result in higher yields compared to taxable bonds, even if the coupon rates are lower.

When considering municipal bonds, it's important to remember that not all municipal bonds are entirely tax-free. Some states do tax municipal bond interest, and there may be tax implications related to Social Security income and the alternative minimum tax. Additionally, if a municipal bond is purchased at a discount on the secondary market, capital gains taxes may apply.

Municipal bonds also offer a relatively low level of default risk compared to other bond types, making them a stable and safe investment option. However, it's crucial to assess the creditworthiness of the issuing entity, as default risks can vary depending on the financial health and management of the local government.

Overall, municipal bonds can be a valuable component of a well-diversified portfolio, especially for high-income individuals seeking to optimise their tax strategies while generating a steady stream of income.

Frequently asked questions