Government entities such as states, counties, cities, and other municipalities issue municipal bonds to raise money. They use the proceeds to fund large public projects like roads, sewers, and schools.
Municipal bonds, also known as munis, usually pay interest twice per year for a specific period of time, or term. At the end of the term, the investor receives the original face value of the bond.
Municipal bonds can be purchased individually or as part of a mutual fund or ETF. Learn how to invest in municipal bonds and more about their pros and cons so you can determine how they may fit into your portfolio.
How To Invest in Tax-Free Municipal Bonds in 3 Steps
- Open an account.
- Decide which municipal bond to buy.
- Make your first transaction.
What You Need To Know Before You Invest in Municipal Bonds
Most individual investors buy municipal bonds because the interest generally is exempt from federal income tax. Because of their tax advantages, they can provide competitive returns with lower interest rates than taxable bonds.
The tax-equivalent yield (TEY) of a bond is the return that a taxable bond needs in order to be equal to the return on a tax-exempt municipal bond. Calculating the TEY on municipal bonds is a key element of determining whether they make sense for your investment portfolio over other taxable bonds.
To calculate the tax-equivalent yield, divide the tax-free municipal bond yield by the reciprocal tax rate. For example, if your tax rate was 25%, your reciprocal tax rate would be 75%.
Tax-equivalent yield = Tax-free muni bond yield / Reciprocal tax rate
So if a municipal bond had a 3% tax rate and your income-tax rate was 25%, a taxable bond would need to provide a 4% yield to give you with the same returns as the municipal bond:
Tax-equivalent yield = 3% / 75% = 4%
Not all municipal bonds are tax-exempt. Interest from bonds used to finance sports facilities or fund public pensions are taxable. Some types of munis, called private activity bonds, are only subject to the alternative minimum tax.
While most municipal bonds are exempt from federal income tax, they are still subject to capital gains tax when they are sold at a profit.
Understand the Risks of Investing in Municipal Bonds
Municipal bonds, like with any investment, carry risks to consider before you invest.
There is a risk that municipal bond issuers may not be able to make interest payments or principal payments at maturity. While defaults are rare, they do occur. Rating agencies such as Moody’s or Standard & Poor’s evaluate and rate the creditworthiness of municipal bonds.
Municipal bonds that are ‘callable’ may be paid off by the issuer before maturity. Investors whose municipal bonds are called may not be able to find a replacement at a similar rate of interest.
Some bonds are more popular than others. A municipal bond that’s not actively traded may have volatile prices and might not be easy to sell immediately for your target price.
The market price of municipal bonds increases or decreases along with broader market trends. As interest rates rise, the market value of the bond falls.
Municipal bonds pay a fixed rate of interest that may not keep up with inflation. Inflation also causes interest rates to rise, which reduces the market value of the bond.
Pros and Cons of Investing in Municipal Bonds
State income tax
Interest included in modified adjusted gross income (MAGI)
May not benefit investors in lower tax brackets
- Tax-free interest: Municipal bonds are exempt from the federal income tax. They’re especially attractive to investors in higher tax brackets.
- Low risk: Municipal bonds generally are considered stable investments with low rates of default.
- State income tax: While municipal bonds generally are exempt from federal income tax, state income tax will often apply. Municipal bonds are only exempt from taxes of the issuing state. For example, a bond issued by the city of Los Angeles would be exempt from California state income tax, but not New Jersey state income tax.
- Interest included in MAGI: Interest from municipal bonds is included in the modified adjusted gross income used to calculate the tax on Social Security benefits and subsidies for ACA health insurance.
- May not benefit investors in lower tax brackets: For investors with modest income, the tax benefit of municipal bonds may not be enough to offset lower rates of return.
How To Start Investing in Municipal Bonds
Open an Account
Municipal bonds usually are sold through a broker-dealer such as Vanguard or Charles Schwab. Broker-dealers sell bonds from their inventory or can buy them on your behalf from other dealers. You can open a self-managed account at a broker-dealer, or you can choose to use the services of a financial professional.
Broker-dealers and other financial institutions will ask for detailed financial and personal information to open an account. After opening the account, you will need to fund it. One easy way to fund your investment account is to link it to your bank account and transfer money.
Self-managed accounts are available from discount broker-dealers such as Fidelity, Schwab, TD Ameritrust, and others with no minimums. Full-service broker-dealers such as Bank of America/Merrill Lynch and Morgan Stanley have minimums and fees depending on the services. All broker-dealer commissions and fees are disclosed in the account agreement.
Decide Which Municipal Bond To Buy
You can invest in municipal bonds through individual bonds, mutual funds, or exchange-traded funds.
- Individual bonds: Individual municipal bonds usually are sold in $5,000 denominations. If you have a limited amount of money to invest, it will be difficult to diversify your holdings when you buy an individual bond. If you plan to see the bond before maturity, you’ll need to consider the maturity risk, which is the risk that if the bond is not actively traded, it may be more volatile in price and harder to sell.
- Mutual funds: Mutual funds accept pooled money from investors to hold multiple securities, which offers diversification and lower minimum investment requirements than individual bonds. Mutual fund prices are set at the close of every trading day. Shares are purchased from and redeemed by the investment company at net asset value (NAV).
- Exchange-traded funds (ETF): Exchange-traded funds also offer diversification and low minimum investments. ETFs are similar to mutual funds in that they hold multiple securities, but their shares are traded like stock on the exchanges throughout the day at market prices.
Make Your First Transaction
Investing in municipal bond mutual funds and ETFs is straightforward. Start by getting a quote, which is easily found on the broker-dealer’s website. Current price, fees, and expenses for mutual funds and ETFs should be transparent. If you’re satisfied with the price, place the order on the broker-dealer’s online order entry system. Mutual fund orders will execute at the end of the day. ETF orders generally execute immediately.
There is no central exchange for the bond market that shows current real-time bid/ask prices like there is for stocks, options, and commodities. The most reliable quote for an individual bond will come from a representative on the bond desk at your broker-dealer.
The bond quote includes the broker-dealer’s markup. If you’re satisfied with the price, you can place the order.
What To Watch Out for After You Invest in Municipal Bonds
Individual bonds, mutual funds, and ETF transactions typically settle within two business days. Cash is debited from your account and the bond or fund shares that you purchased will be delivered. Dividend payments from a bond fund or ETF generally are paid monthly, and the amount will vary based on the portfolio. Individual municipal bond interest generally is paid semiannually.
Keep in mind that the market value of a bond, bond fund, or ETF will fluctuate based on changes in interest rates.
Should You Invest in Municipal Bonds?
Most investors buy municipal bonds for the tax-free income and low risk profile. If you aren’t in a high-income tax bracket or income is not your primary objective, consider how municipal bonds will fit into your strategy before you invest. Municipal bonds generally are not recommended for IRAs or 401(k) accounts that already offer tax advantages.
Frequently Asked Questions (FAQs)
How can beginners invest in municipal bonds?
Municipal bonds aren’t for every investor. If you’re just beginning, consider getting advice from a financial professional to develop a strategy that aligns with your goals before you invest in municipal bonds. Beginners can invest by buying a bond directly, or investing in a mutual fund or exchange-traded fund (ETF) that holds multiple municipal bonds.
Do I need a lot of money to invest in municipal bonds?
Individual municipal bonds usually are issued in face amounts of $5,000. Mutual funds and ETFs offer exposure to thousands of municipal bonds. In some cases, the minimum investment is less than $100.
What is the best way to invest in municipal bonds?
The easiest way to invest in municipal bonds is through a mutual fund or ETF. Mutual funds and ETFs provide diversification, which helps lower risk. They also have low minimum investment requirements, and they’re easy to buy.
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