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Types of Municipal Bonds and Their Risks

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Municipal bonds allow investors to lend money to local governments so that they can fund daily operations as well as public works projects, such as road construction, improvements to schools and hospitals, and more. The primary benefit of municipal bonds, also called “munis”, is that they’re exempt from federal taxes and most state and local taxes.

If you’re looking for ways to invest a substantial amount of extra cash, investing in municipal bonds could be a good option for you. But like any investment venture, there are a number of municipal bonds risks to consider before you get started.

Here, we’ll explain how different types of municipal bonds work and the level of risk that may be involved. Read on to learn the ins and outs of this investment type, or use the links below to skip to the section you’re most interested in.

What are Municipal Bonds?

Municipal bonds are a type of investment where individuals lend their money to local governments; the municipality can then use the funds to conduct daily operations and pay for public works projects. Municipal bond funds can be used to finance projects such as freeway and bridge construction, road repairs, school and hospital construction, etc.

 

When an investor purchases a municipal bond and effectively lends the local government money, the municipality agrees to pay back the principal investment by the maturity date, plus regular interest payments. 

If municipal bonds sound like they could be a good investment option for you, keep in mind that they usually require a minimum investment of $5,000. 

Don’t have thousands to invest just yet? Other investments opportunities, like AI investing and high-yield savings offer lower-cost options.  

How long does it take for municipal bonds to mature? 

According to Investor.gov, it could be several years past the initial investment. For this reason, municipal bonds tend to be a better option for long-term investing, because you may not get a return until many years down the road.

Are municipal bonds taxable? 

As we briefly mentioned at the start of this post, tax benefits are one of the most attractive aspects of municipal bonds. Typically, the interest collected on municipal bonds is not taxable by the federal government. What’s more, they’re often exempt from state and local taxes as well.

Are municipal bonds safe?

Municipal bonds generally align with long-term investment strategies more so than short-term options. Many investors who opt for municipal bonds are more interested in preserving than accelerating their wealth and are often considered more risk-averse than stock investors. 

With that said, there are some risks associated with this type of investment—we’ll explore those risks in more detail a bit later on.

How to buy municipal bonds

According to FINRA, a government-sponsored investment regulator, there are five ways investors can buy municipal bonds:

  1. Consult a broker-dealer or your bank’s municipal securities dealer
  2. Hire an investment adviser to help you locate and trade municipal bonds
  3. Use an online investment platform to trade on your own
  4. Buy or sell shares in a municipal bond mutual fund
  5. Buy or sell shares in a municipal bond ETF

Different Types of Municipal Bonds

Now that you’re familiar with the basics of investing in municipal bonds, it’s time to take a look at the different types of muni bonds you can purchase. According to Investor.gov, general obligation bonds and revenue bonds are the two most common types. We’ll take a look at these first and then define a few additional options below.

General obligation bonds (GOs)

General obligation bonds can be issued on the state, city, or county level. Although these types of mutual bonds are not secured by any assets, the municipality may leverage taxes collected by residents in order to pay bond investors.

Revenue bonds

Revenue bonds do not come with the taxing authority that GOs do, but are backed instead by revenue from profitable projects. Highway tolls, for example, may be used to pay bondholders.

Taxable municipal bonds

Taxable municipal bonds are fixed-income securities issued by city, county, or related entities. The bond funds are used to fund projects that are not subsidized by the federal government because they do not directly benefit the public, and are therefore not considered tax-exempt. However, taxable municipal bonds tend to offer higher interest rates, which can make them an attractive option for certain investors.

Zero-coupon bonds

Zero-coupon bonds are a kind of municipal bond that do not generate interest but instead offer trading at substantial discounts from their original face value. Investors can profit on this option when the bond reaches maturity, which is often after ten or more years.

Pre-refunded bonds

Pre-refunded bonds allow bond issuers to pay off their principal and interest before the bond’s maturity date. We’ll explore the municipal bond risks associated with pre-refunded bonds a little later on in this post.

Escrowed-to-maturity (ETM) bonds

Municipal bonds that are escrowed to maturity are a type of pre-funded municipal bond backed by Treasury securities kept in an escrow account.

Housing bonds

Housing bonds are a type of municipal bond where bond funds are allocated exclusively toward affordable housing development.

Conduit bonds

Conduit bonds are used to help finance projects for private companies, non-profits, and public agencies. Though they may be proposed by private companies or non-profit organizations, these projects are usually intended for the benefit of the public.

Municipal Bond Risks

Like all investments, municipal bonds have several risks that are worth considering before investing your hard-earned cash. As you conduct your research and evaluate your investment goals, consider the following municipal bond risks:

Call risk

Call risk is the possibility that a bond issuer may repay the bond before it matures. This may happen if they want to benefit from lower interest rates, which happens most commonly with pre-refunded bonds. To prevent this risk, investors can review the “call provisions” before moving forward with their purchase.  

Credit risk

Credit risk is the possibility that the bond issuer may not be able to repay the principal investment and/or interest in full. This can occur if the bond issuer, in this case, a local municipality, experiences serious financial setbacks that result in them defaulting.

This risk can be mitigated by reviewing credit ratings on bonds before agreeing to invest. Credit ratings are generally available but aren’t a guarantee that a specific bond is “safe” or worth pursuing.

Interest rate risk

Bonds have a fixed face value, known as the “par” value. If bonds are held until their 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. If interest rates increase, investors who hold a low fixed-rate municipal bond may lose money trying to sell it before it matures.

Inflation risk

Inflation can decrease a bond issuer’s purchasing power and also lead to high-interest rates, which can translate to lower market values for current bonds.

Liquidity risk

Liquidity is a common investment term used to describe how easily an investor can “liquidate” or cash in on their investment. With municipal bonds, liquidity can become a risk if there’s not an active market when an investor decides that it’s time for them to sell. This could mean they’re unable to sell all together or could result in a lower selling price than expected.

The Bottom Line

If you’re looking for a long-term investment to help you preserve your wealth, municipal bonds may be a good route. However, there are several prerequisites, like a minimum $5,000 investment, and a number of risks to assess before you get started. 

Use this guide to help you evaluate how municipal bond risks and rewards align with your investment goals. And head over to the investing advice category of our blog for more resources to help you grow your financial wealth and knowledge.  

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