Municipal bonds, also called munis, are a type of debt security issued by local governments, such as a city, state or municipality, to fund government projects. They appeal to many investors because of their tax-exempt interest and their diversification potential.
If you’re thinking about adding municipal bonds to your portfolio, there’s a lot to know. Let’s talk about what municipal bonds are, their main advantages and four ways to buy municipal bonds.
What are municipal bonds?
Municipal bonds are a form of debt obligation issued by a government entity in order to finance various types of projects. There are two types of munis:
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General obligation bonds: This type of municipal bond allows the government to tax residents in order to pay back bond holders. They aren’t necessarily backed by a specific government project but by general government funds or specific tax revenues.
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Revenue bonds: This type of muni is issued to fund a specific project, like the construction of a water treatment plant or hospital. The revenue from that project or service pays for the bond.
The interest earned on municipal bonds is exempt from federal income tax (and in some cases, state and local tax as well), making them potentially attractive to investors in higher tax brackets. While municipal bonds generally have lower interest payments compared to other bond types, the tax benefits can sometimes outweigh the higher returns on other categories of bonds, like corporate bonds or Treasury bonds.
Municipal bonds may also be a good fit for your portfolio if you are looking for bonds with a low risk of default or want to avoid the potential volatility associated with corporate bonds or stocks.
With some of these benefits in mind, here are four ways to invest in municipal bonds.
4 ways to invest in municipal bonds
There are several ways to invest in municipal bonds, but the most common include purchasing individual municipal bonds, buying muni mutual funds or exchange-traded funds (ETFs) and creating municipal bond ladders.
1. Individual municipal bonds
If you have a long-term investment horizon, are an experienced investor or have a high net worth, purchasing munis individually might be the way to go.
You can purchase a muni as a singular investment through your own brokerage account or through a broker who conducts the transaction for you. While you might be able to purchase a muni through your brokerage account, it will likely be more expensive than investing in a fund.
Purchasing bonds individually also requires research and analysis regarding the issuer’s debt credibility and default risk. Individual municipal bonds might also be less liquid than other asset types, which can make them a challenge to sell down the line.
Additionally, achieving diversification across individual muni bonds can take a lot of time and money. But the decision to do so depends on your individual goals, risk tolerance and how comfortable you are with managing your own investment portfolio.
2. Municipal bond mutual funds
While purchasing an individual municipal bond may appeal to some investors, it’s often much easier to invest in a municipal bond fund, which gives you exposure to a diversified portfolio of munis. This also reduces the risk associated with buying individual bonds.
The process for investing in municipal bond mutual funds is the same as investing in any other mutual fund. Anyone with a brokerage account at a reputable financial institution will be able to make the purchase easily.
3. Municipal bond exchange-traded funds (ETFs)
ETFs are baskets of securities — usually just one type — that trade on a stock exchange and are usually passively managed. There are many ETFs that hold municipal bonds, which allows investors to own a stake in each of the bonds within the fund.
Municipal bond ETFs have many of the same advantages of municipal bond mutual funds in that they can help diversify your portfolio and reduce the risk of investing in a single bond. ETFs and mutual funds do have some key differences though.
ETFs also are popular with investors because they’re easy to invest in with a brokerage account and have relatively low expense ratios.
4. Municipal bond ladders
A bond ladder is an investment strategy in which the investor purchases several individual bonds with different maturity dates to help mitigate the impact of interest rate changes over time and ensure steady income. The idea is that once a bond matures, you reinvest that money into a new bond on the ladder and maintain consistent income over time.
You can form a bond ladder by purchasing several individual municipal bonds with different maturity dates to ensure stable income over time and reap the rewards if interest rates rise in the future.
Since it can be more difficult to purchase municipal bonds on an individual basis, consider working with a financial advisor who may be able to help you select the municipal bonds that best fit your portfolio and long-term financial goals. An advisor may also help you manage your bond ladder, reinvest your earnings and give you tax advice.
Need an advisor?
Looking for expert guidance when it comes to managing your investments or planning for retirement? Bankrate’s AdvisorMatch can connect you to a CFP® professional to help you achieve your financial goals.
Bottom line
Purchasing individual municipal bonds might not be for every investor, given the level of research and money to reach a solid level of diversification within your portfolio. If that route isn’t for you, consider mutual funds or ETFs that spread your investments out across different municipal bonds and give you automatic diversification.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.