Investing Assets & Markets Bonds The Risks of Municipal Bonds By Thomas Kenny Updated on October 25, 2022 Reviewed by Anthony Battle Fact checked by Sarah Fisher Fact checked by Sarah Fisher Sarah Fisher is an associate editor at The Balance with two years of personal finance and business writing experience. She has written about personal finance for SmartAsset, and has held internships at the Consumer Financial Protection Bureau and Senator Kirsten Gillibrand's office. learn about our editorial policies In This Article View All In This Article Headline Risk Interest Rate Risk Low Default Risk and Rate Low Default Rate The Bottom Line Frequently Asked Questions (FAQs) Photo: Makiko Tanigawa / Getty Images Municipal bonds often offer a good yield edge over U.S. Treasuries for investors in higher tax brackets. Still, how much will you pay in terms of risk to pick up the added yield? In short, there is not as much risk as you may think, but there is always some risk to be aware of when investing. You should be aware of the risks if you are thinking about muni bond investing. There is a fairly low rate of default risk, but interest rate risk and headline risk do exist. Key Takeaways If municipal bond defaults make the news, that can scare investors and bring down the price of municipal bonds.The risk of municipal bond default is less than 1%.Although the risk of municipal bond default is extremely low, it can still happen, so make sure you do your research. Headline Risk Headline risk refers to the risk that comes from bad news going public. Municipal bonds face the risk of adverse headlines because high-profile defaults tend to make the news. A prime instance of headline risk occurred in late 2010. An analyst predicted that slowing economic conditions could lead to hundreds of billions of dollars in defaults among municipal issuers. This forecast spooked investors and drove the municipal market down nearly 6% in the weeks that followed. When the market finally hit its low two months later, the municipal market had lost almost 10% of its value from the time of the interview. Note Municipal bond market downturns related to the news can be a great time to invest in municipal bonds. That way, you can purchase these bonds when the price is low, and you can get a higher interest rate, or sell the bonds when the price goes up. Interest Rate Risk While default risk is low, muni bonds are subject to interest rate risk, or the risk that rising rates will lead to falling prices. This is even more true for investors in bond funds and exchange-traded funds (ETFs) that invest in munis. If Treasury yields go up (meaning that prices are falling), it is very likely that muni bonds will follow suit. Investors will see their principal value decline even if defaults remain low. As a result, it's vital to make sure that where you choose to invest is suited to your time frame, goals, and risk tolerance. When looking at a fund, it pays to take the time to find out how the manager of the fund did in down markets, what kind of track record they have, and the nature of the securities in which the fund is invested. Low Default Risk and Rate Based on a study by the fixed income rating agency Moody's, yields on municipal bonds fairly compensate investors for the added risks. In the 42-year period that ended with 2011, 100% of Aaa-rated muni bonds brought all of the expected interest and principal payments to investors. In the same period, 99.9% of Aa-rated bonds did the same. The ratings come from Standard & Poor's general-purpose ratings. Aaa is the highest possible rating; Aa is the second-highest. Overall, very few municipal bonds defaulted. Only .08% of muni bonds defaulted between 1970 and 2021, and the average five-year municipal default rate between 2012 and 2021 was .1%. Higher-quality bonds tend to perform better than lower-rated securities even during times of economic distress. This is due to the underlying issuers keeping sufficient financial strength to keep making their payments even under adverse conditions. Low Default Rate Keep in mind that the price of a defaulted bond does not always go to zero. Investors can often expect some degree of recovery. While muni bonds carry their share of risks, this is ample evidence that the chance of defaults in the muni market is very low. You can greatly reduce your risk of muni bond default through a focus on higher-quality securities. Of course, the risk of municipal bankruptcy or inability to pay bondholders is still there, even though it is low. The Bottom Line The risk that any single muni bond with a high credit rating will default is very low. Still, anyone putting cash into an individual issue needs to do a lot of research. While it is useful to know that defaults are rare, it's also vital to keep in mind that other risk factors come into play. Frequently Asked Questions (FAQs) What are the advantages and disadvantages of municipal bonds? The interest you make from municipal bonds are typically exempt from federal income taxes. If the bond is issued by the state you pay taxes in, you generally won't have to pay taxes on the interest you earn. However, municipal bonds usually have lower interest rates than corporate bonds with similar terms. What are the tax risks associated with investing in a municipal bond? Although the interest is typically not taxable, capital gains are taxable. The interest earned from a municipal bond may also increase your Social Security taxes, and can be considered part of the income that affects your monthly Medicare premiums. In addition, if you purchase a municipal bond from outside of your home state, the interest you earn may be subject to income tax, depending on the laws of your state. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. S&P Global. "S&P Global Ratings Definitions." Seeking Alpha. "Muni Defaults: Should Investors Worry?" Charles Schwab. "Why Widespread Muni Defaults Are Unlikely to Happen."