What are Municipal Bonds (and Why Should Anyone Care)?
Municipal Bonds 101
Municipal bonds are not flashy. They are generally low-risk and don’t generate large returns. It’s easy for aggressive investors to overlook them.
So what are they, and why should anyone care?
A municipal bond is a debt security that government agencies issue to pay for public projects. They fund the construction of schools, highways and bridges, libraries, sewage systems, and more. Think of municipal bonds as loans made by investors to government entities. The municipality pays regular interest on the loan until the bond “matures”. Then the municipality redeems the “face amount” to the investor/lender.
Two Types of Municipal Bonds
Municipal bonds can be categorized by the way they generate money to make the periodic interest payments and principal repayments at bond maturity. There are two common types of municipal bonds:
- Revenue Bonds are supported by the income generated by the project, such as a toll road project. Tolls, or sales tax, or fuel tax, or hotel occupancy tax or other types of taxes can be used as revenue sources for paying interest on the bond and repaying the initial principal.
- General Obligation Bonds use a percentage of property taxes or general funds to pay interest and principal.
Both are typically tax-exempt from state and local taxes.
Variability of Bond Issuers
Municipal bonds are low-risk, but not zero risk. To help investors evaluate the risks involved in municipal bonds, ratings agencies, such as Standard & Poor’s and Moody’s Investors Service, analyze the strength and creditworthiness of bond issuers and assign ratings to them. The ratings are similar to school grades, with “AAA” being the most creditworthy, down to D’s for those in default.
Bond issuers with the highest ratings typically pay the lowest amount of interest. This reflects the low risk and high likelihood of making all interest payments and repayments of principal. Conversely, bond issuers with lower ratings will typically offer a higher interest rate, reflecting the higher risk to the investor.
The Costs of Municipal Bonds
While a particular bond’s interest rate and payments are fixed amounts over their lifetimes, market interest rate fluctuations can affect the price of a particular bond.. For example:
- When interest rates go down, newly issued bonds will pay less interest (lower yield) than previously-issued bonds. This makes the older bonds with higher yields more attractive than the new ones. Investors may pay more for older bonds in this situation, seeking higher yields .
- When interest rates rise, newly issued bonds will pay a higher yield than previously-issued bonds. This makes the older bonds less attractive than new ones. Investors may expect a discount on older bonds in this situation.
However, if you buy a municipal bond and keep it until it matures, interest rates and economic fluctuations would not be meaningful factors.
Why Anyone Should Care
The upside to municipal bonds is their very low default rate and (in most cases) tax-exempt earnings.The bonds pay fixed rates over their lifetimes, which provide stability. (Individuals on fixed income appreciate that.) Municipal bonds allow you to hold on to your capital and create a tax-free income source.
But because they are low-risk and their interest is usually exempt from taxes, they pay lower interest rates. Additionally, with fixed payouts, it is possible for inflation to eclipse yields.Due to rising state and federal income tax rates and growing investor wealth, demand for these bonds has grown. Liquidity in the market place is good — particularly for high-quality, larger issuers and in states where “natural” demand (due to high state income taxes) is strong.
Depending on your specific investment needs, goals and risk tolerance, municipal bonds may be a valuable part of a diversified investment portfolio.
If you are actively investing, or thinking about starting, visit with a Registered Investment Advisor. To learn more about what an Investment Advisor should do for you, click here to download our free eBook “3 Things an Investment Advisor Should Do for You”.
A University of Washington graduate with local ties, Bruce Rinne is a founding partner of Kunath Karren Rinne & Atkin, LLC. As a portfolio manager, he focuses on managing fixed income, cash and balanced portfolios for our clients. He prides himself on his deep connection with clients and the level of service KKRA provides. Prior to forming KKRA, Bruce worked with Ned Karren as a senior portfolio manager at Seafirst Investment Advisors, where he began his career in investment management.
Tags: growing your money, investments, municipal bonds