What are municipal bonds?
Municipal bonds (or “munis” for short) are debt securities issued by states, cities, counties and other governmental entities to fund day-to-day obligations and to finance capital projects such as building schools, highways or sewer systems. By purchasing municipal bonds, you are in effect lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or “principal.” A municipal bond’s maturity date (the date when the issuer of the bond repays the principal) may be years in the future. Short-term bonds mature in one to three years, while long-term bonds won’t mature for more than a decade.
Generally, the interest on municipal bonds is exempt from federal income tax. The interest may also be exempt from state and local taxes if you reside in the state where the bond is issued. Bond investors typically seek a steady stream of income payments and, compared to stock investors, may be more risk-averse and more focused on preserving, rather than increasing, wealth. Given the tax benefits, the interest rate for municipal bonds is usually lower than on taxable fixed-income securities such as corporate bonds.
The two most common types of municipal bonds are the following:
- General obligation bonds are issued by states, cities or counties and not secured by any assets. Instead, general obligation are backed by the “full faith and credit” of the issuer, which has the power to tax residents to pay bondholders.
- Revenue bonds are not backed by government’s taxing power but by revenues from a specific project or source, such as highway tolls or lease fees. Some revenue bonds are “non-recourse”, meaning that if the revenue stream dries up, the bondholders do not have a claim on the underlying revenue source.
In addition, municipal borrowers sometimes issue bonds on behalf of private entities such as non-profit colleges or hospitals. These “conduit” borrowers typically agree to repay the issuer, who pays the interest and principal on the bonds. In cases where the conduit borrower fails to make a payment, the issuer usually is not required to pay the bondholders.
Where can investors find information about municipal bonds?
Investors wishing to research municipal bonds may access a range of information online free of charge at the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access (EMMA) website. Information available to you includes:
- Disclosure documents going back as early as 1990, including a bond’s official statement, which is a disclosure document similar to a prospectus that includes important characteristics, such as type, yield, maturity, credit quality, call features and risk factors, as well as audited financial statements, material event notices and other continuing disclosures (including ratings changes, principal and interest payment delinquencies and non-payment related defaults).
- Historical and real-time transaction price data, including information relating to a type of municipal bond called a “variable rate demand obligation” that resets its interest rate periodically. Investors should be aware that recent price information may not be available for bonds that do not trade frequently.
What are some of the risks of investing in municipal bonds?
As with any investment, investing in municipal bonds entails risk. Investors in municipal bonds face a number of risks, specifically including:
Call risk. Call risk refers to the potential for an issuer to repay a bond before its maturity date, something that an issuer may do if interest rates decline -- much as a homeowner might refinance a mortgage loan to benefit from lower interest rates. Bond calls are less likely when interest rates are stable or moving higher. Many municipal bonds are “callable,” so investors who want to hold a municipal bond to maturity should research the bond’s call provisions before making a purchase.
Credit risk. This is the risk that the bond issuer may experience financial problems that make it difficult or impossible to pay interest and principal in full (the failure to pay interest or principal is referred to as “default”). Credit ratings are available for many bonds. Credit ratings seek to estimate the relative credit risk of a bond as compared with other bonds, although a high rating does not reflect a prediction that the bond has no chance of defaulting.
Interest rate risk. Bonds have a fixed face value, known as the “par” value. If bonds are held to maturity, the investor will receive the face value amount back, plus interest that may be set at a fixed or floating rate. The bond’s market price will move up as interest rates move down and it will decline as interest rates rise, so that the market value of the bond may be more or less than the par value. U.S. interest rates have been low for some time. If they move higher, investors who hold a low fixed-rate municipal bond and try to sell it before it matures could lose money because of the lower market value of the bond.
Inflation risk. Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. It also can lead to higher interest rates and, in turn, lower market value for existing bonds.
Liquidity risk. This refers to the risk that investors won’t find an active market for the municipal bond, potentially preventing them from buying or selling when they want and obtaining a certain price for the bond. Many investors buy municipal bonds to hold them rather than to trade them, so the market for a particular bond may not be especially liquid and quoted prices for the same bond may differ.
In addition to the risks, what other factors should you consider when investing in municipal bonds?
Tax implications. Consider consulting a tax professional to discuss the bond's tax implications, including the possibility that your bond may be subject to the federal alternative minimum tax or eligible for state income tax benefits.
Broker compensation. Most brokers are compensated through a markup over the cost of the bond to the firm. This markup is usually not disclosed on your confirmation statement. If a commission is charged, it will be reported on your confirmation statement. You should ask your broker about markups and commissions.