Why Invest in Municipal Bonds

Investing in municipal bonds (“muni bonds” or “munis” for short) can be a smart strategy for wealth building. Municipal bonds are debt securities issued by state and local governments to fund public projects, offering tax-free income, low default rates, and portfolio diversification. In this blog post, we will delve into the benefits of investing in municipal bonds and provide tips on finding the best individual bonds and evaluating their risks and returns.

Whether you’re a seasoned investor or just starting, adding municipal bonds to your portfolio can provide a stable source of income and help you achieve your financial goals.

What are the advantages of investing in municipal bonds?

Investing in municipal bonds offers a range of advantages for investors. Here are some key benefits to consider:

  1. Tax-Free Income: One of the most attractive features of municipal bonds is that the interest income they generate is typically exempt from federal taxes. In certain cases, they may also be exempt from state and local taxes if you reside in the issuing municipality. This tax advantage can significantly boost your after-tax returns, making municipal bonds an excellent choice for investors in higher tax brackets.
  2. Stable and Predictable Income: Municipal bonds are known for providing a steady stream of income. Unlike stocks or other investments that can experience volatile swings in value, municipal bonds typically offer a reliable income stream, with regular interest payments paid to bondholders. This stability makes them an appealing choice for investors seeking a consistent cash flow.
  3. Low Default Rates*: Historically, municipal bonds have exhibited lower default rates* compared to corporate bonds. This is because municipalities have the power to levy taxes and generate revenue to meet their debt obligations. Additionally, many municipal bonds are backed by essential public services, such as schools or water systems, which further enhances their creditworthiness. Note that defaults can still occur, especially with lower-rated bonds.
  4. Diversification: Including municipal bonds in your investment portfolio can provide diversification benefits. Municipal bonds have a low correlation with other asset classes, such as stocks and real estate, meaning their performance is often independent of these investments. By adding municipal bonds to your portfolio, you can reduce the overall risk of your investments and potentially improve your overall returns.

Are there risks associated with investing in municipal bonds?

As with any investment, there are risks associated with investing in municipal bonds. Again, while municipal bonds are generally considered to be low-risk investments, it is important for investors to be aware of the potential risks involved.

Credit risk

The creditworthiness of the issuer is a key risk factor. Municipal bonds are backed by the issuing government’s ability to generate revenue through taxes or fees. If the issuer’s financial condition deteriorates, it may have difficulty making interest or principal payments on the bonds, leading to a default. Investors should carefully evaluate the creditworthiness of the issuer before investing.

Interest rate risk

Municipal bonds are sensitive to changes in interest rates. When interest rates rise, the market value of existing bonds tends to decline. This is because investors can get higher yields from newly issued bonds. On the other hand, when interest rates fall, the market value of existing bonds tends to increase. Investors should consider their investment horizon and the potential impact of interest rate changes on the value of their bond holdings.

Market risk

Like all investments, municipal bonds are subject to market fluctuations. Economic conditions, geopolitical events, and investor sentiment can all affect the market value of bonds. It is important for investors to diversify their bond holdings and consider their risk tolerance when investing in municipal bonds.

Reinvestment risk

As you receive income from bond interest payments or returned principal from called or matured bonds, you may want to reinvest those proceeds. As market conditions change, you may not be able to receive the same interest rates as the previous bonds. Lower interest rates on reinvested proceeds will mean lower income.

Despite these risks, investing in municipal bonds can still be a lucrative investment strategy.

When evaluating municipal bonds, investors should carefully review the issuer’s financial statements, credit ratings, and any potential risks associated with the specific project being funded. It can also be helpful to diversify your investment by investing in bonds from different issuers and across different sectors.

By understanding the potential risks and conducting thorough research, investors can make informed decisions and maximize the benefits of investing in municipal bonds.

What are the types of municipal bonds available?

Municipal Bonds are issued by state and local governments for many different types of purposes. Possibly the most important distinction among different types of municipal bonds is the source of income the issuer uses to pay back the investor. These include:

General Obligation Bonds (GO Bonds)

These bonds are backed by the full faith and credit of the issuing government entity. They are considered the safest type of municipal bond since the issuer has the ability to raise taxes to repay the bondholders if necessary. GO bonds are generally used to fund essential public projects such as schools, hospitals, and infrastructure.

Revenue Bonds

Unlike GO bonds, revenue bonds are backed by the revenues generated from a specific project or facility. These bonds are often issued to finance projects such as toll roads, airports, or water treatment plants. The repayment of revenue bonds is dependent on the success of the project generating the revenue.

In addition, municipal bonds are issued for many different types of state and local government purposes. For example:

Industrial Development Bonds (IDBs)

IDBs are issued by state and local governments to provide financing for industrial or manufacturing projects. These bonds are often used to support economic development initiatives and create jobs. IDBs are typically secured by the assets of the project being financed.

Housing Bonds

Housing bonds are issued to finance the construction, acquisition, or rehabilitation of affordable housing projects. These bonds are backed by the rental income or mortgage payments from the housing units. They are often used to address the shortage of affordable housing in communities.

Another difference to be aware of is the way various municipal bond issues categorize interest income for tax purposes.

The income generated from municipal bonds is generally exempt from federal taxes, but they may still be subject to state and local taxes depending on where you live. It’s important to consult with a tax advisor to understand how investing in municipal bonds may impact your individual tax situation.

Also, there are some municipal bonds that are taxable. These bonds are typically issued for projects that do not meet the requirements for tax-exempt status, such as stadiums or convention centers. While the interest earned on these bonds is subject to federal income tax, they may still offer attractive yields compared to other taxable investments.

Certain Municipal bonds may also be subject to the Alternative Minimum Tax which taxes the proceeds from certain bonds based on the overall tax status of the investor.

And finally, for bonds purchased at a market discount or bonds identified as “OID” (original issue discount) the difference between the purchase price and par value may be treated as taxable interest rather than capital gain. Gains on sales/redemptions of all municipal and corporate bonds may be taxed as capital gains.

It’s important to consult with a tax advisor to understand how investing in municipal bonds may impact your individual tax situation.

How does Hennion & Walsh decide which bonds to recommend for your portfolio?

  1. We Research the Issuer: Before investing in a municipal bond, it’s important to research the issuing government entity. Look into their financial stability, credit rating, and overall economic conditions of the region. This will give you an idea of the issuer’s ability to repay the bond.
  2. We evaluate the Bond’s Credit Quality: Credit ratings provided by agencies such as Standard & Poor’s, Moody’s, or Fitch can give you an indication of the bond’s credit quality. Bonds with higher ratings are generally considered less risky.
  3. The yield is considered: The yield on a municipal bond is another important factor to consider. Higher-yielding bonds may offer more income potential, but they often come with higher risks. Evaluate the yield in relation to the bond’s credit quality and your own risk tolerance.
  4. We make sure your Portfolio is diversified: Just like with any investment, it’s important to diversify your holdings. Consider investing in bonds from different issuers, regions, and sectors to spread out your risk. This can help protect your portfolio from any potential negative impacts in a specific area or sector. Diversification can also include investing in both general obligation and revenue bonds, as well as bonds with different maturities.
  5. We provide Professional Management: If you’re unsure about selecting individual municipal bonds or don’t have the time to research and monitor them, you may want to consider investing in a municipal bond fund. These funds are managed by professionals who select and manage a diversified portfolio of municipal bonds on your behalf.
  6. After the purchase, we keep you Informed: Once you’ve invested in municipal bonds, it’s important to stay informed about any changes or developments that may impact your investments. Keep an eye on the financial health of the issuer, any news or events that may affect the bond’s performance, and changes in interest rates or tax laws.

In conclusion, investing in municipal bonds can be a beneficial addition to any investor’s portfolio. They offer tax-free income, low default rates, and the potential for stable returns.

By conducting thorough research, evaluating the risks and returns, and staying informed, investors can make informed decisions and maximize the benefits of investing in municipal bonds.

 

Disclosures: Investing in bonds involves risk including possible loss of principal. Income may be subject to state, local or federal alternative minimum tax. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. If sold or called prior to maturity the amount received may be less than the amount paid, and the yield received may be less than the yield calculated at purchase. Past performance is not a guarantee of future results. *Investment grade municipal bonds had a cumulative 10-year default rate of 0.09% between 1970 and 2021 according to Moody’s Investor Service, April 21, 2022 “US Municipal Bond Defaults and Recoveries”, 1970–2021.

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