Municipal bonds, also known as muni bonds, are debt securities issued by local governments and agencies to help fund public projects and services. From building schools and hospitals to improving roads and sewer systems, municipal bonds finance the infrastructure that local communities need. These bonds offer some attractive benefits for investors and traders but also come with risks to consider.

Learn the pros and cons of trading municipal bonds to help you determine if they are a good fit for your financial portfolio.

What are municipal bonds?

Municipal bonds are issued by local governments like cities, counties, states and their agencies to raise capital for public projects and services. When you purchase a municipal bond, you are lending money to the issuer in exchange for a predetermined interest payment over a set period of time. At the bond’s maturity date, the issuer also pays back the original principal amount loaned.

There are short- and long-term municipal bonds, with maturities ranging from 1 to 30 years or more. The two major types of munis are:

• General obligation bonds: Issued by municipalities and backed by the issuer’s full faith, credit and taxing power. Tax revenues are used to repay these bonds.
• Revenue Bonds: Repaid through the revenues from a specific project or tax source. These carry a higher risk than general obligation bonds.

According to the Securities Industry and Financial Markets Association (SIFMA), a trade association operating in the United States and global capital, the outstanding amount of municipal bonds in the US is nearly $4 trillion. This indicates that State and local governments heavily rely on these bonds to finance their growth and development projects. Therefore, municipal bonds are a popular asset among investors for trading.

Tax benefits of municipal bonds

The biggest draw of municipal bonds is that interest earned is exempt from federal income taxes. This tax exemption comes because the interest paid is on debt to fund public projects and services. Some states also exempt in-state municipal bond interest from state income taxes. This gives munis a tax-equivalent yield advantage over other bonds like Treasuries or corporate bonds.

For example, a municipal bond with a 4% yield would be equivalent to a corporate bond yielding 6.15% for an investor in the 35% bracket. The taxable equivalent yield allows you to compare municipal bonds to taxable fixed-income products. The higher your tax bracket, the more attractive the tax-exempt yield is. This tax advantage is the key benefit of municipal bonds.

Pros of trading in municipal bonds

Beyond their tax-exempt status, municipal bonds offer other potential benefits for investors who understand their risks and quirks. Here are some of the major pros of trading municipal bonds:

Diversification for Your Portfolio

Municipal bonds offer diversification relative to stocks and corporate bonds in an investment portfolio. Their returns have a low correlation with equities and corporate debt. When stock prices decline, muni bonds may hold steady or increase in value as investors shift to safer assets. This diversification and reduced volatility help manage overall portfolio risk.

Give this article a read for more details: How to diversify your portfolio for 2021

Low default risk

One of the biggest risks of any bond investment is that the issuer will default and be unable to make scheduled principal and interest payments. Corporate bonds tend to have higher default risk than government bonds. However, municipal bonds issued by local governments have had extremely low default rates historically.

Municipalities go bankrupt very rarely given their ability to raise taxes and cut services to pay off debt obligations. Debt issued by cities and counties is backed by the taxing power of the local government. Revenue bonds tied to public utilities and projects like toll roads also rarely default, given they fund essential needs for commuters and transportation groups.

More stability than stocks

While municipal bonds are not completely immune from interest rate shifts and economic swings, they tend to be more stable in price compared to trading stocks. Their interest payments and scheduled return of principal provide more certainty than the volatile capital appreciation of equities. Risk-averse investors like the relative stability of municipal bonds.

Support public projects

There are some non-financial benefits of investing in municipal bonds as well. Those funds directed into ‘munis’ help build and maintain essential infrastructure and services at the local level. Bond investors enable growth and improvements for the communities they live and work in.

Risks involved with municipal bonds

While municipal bonds offer attractive tax-exempt income, investors need to weigh some risks involved with trading these debt instruments:

Lower nominal yields

The main tradeoff for earning tax-exempt income on municipal bonds is that their nominal yields are lower than taxable bonds. Issuers can offer lower interest rates since investors accept this in exchange for tax savings. For example, a 10-year Treasury bond may yield 3%, while an AAA-rated muni yields just 2%.

Liquidity can be low

The municipal bond market is highly fragmented compared to Treasuries and corporate bonds. There are many municipal bonds from small issuers, which reduces liquidity and makes them harder to trade than other fixed-income products.

For investors looking for easier trade ability, it’s important to look for municipal bonds from more established issuers that regularly come to market. By doing so, they can benefit from better price transparency and potentially lower transaction costs.

Subject to interest rate risk

Municipal bonds, like all bonds, are influenced by interest rates. As interest rates rise, the prices of municipal bonds decline since new issues offer higher yields. Among municipal bonds, those with longer maturity dates generally have a greater sensitivity to fluctuations in interest rates. This can make them more volatile and unpredictable than shorter-term bonds.

Complex market to navigate

Investing in municipal bonds can be challenging for investors due to the diverse range of issuers, maturities, credit ratings, and geographical differences associated with this asset class. Therefore, it is required to conduct thorough due diligence to select the appropriate bonds and steer clear of potential risks. In case of any confusion, seeking guidance from a specialist in municipal bonds can be extremely helpful.

Default risk still exists

It’s a rare occurrence, but some municipalities may default on their bonds due to local economic difficulties or poor fiscal management. Before investing, research the financial health of any municipality to prevent the possibility of losing your principal investment. It’s important to note that revenue bonds backed by struggling projects or assets carry a higher risk. Therefore, it’s recommended to exercise caution and carefully evaluate all factors before investing in such bonds.

Alternative Minimum Tax Impact (AMT)

Municipal bonds are a popular investment option for individuals seeking to generate tax-free income. However, it’s important to note that not all municipal bond income is exempt from federal taxes. If a bond funds private activities, it may be subject to the Alternative Minimum Tax (AMT), which could reduce the tax benefits for high-income earners. It’s necessary to determine whether a bond is AMT-exempt before trading.

Vulnerable to local economic troubles

Municipal bonds are influenced by the economic health of the local area that issues them. A struggling local economy means lower tax revenues, more strain on budgets, and more significant challenges to handle existing debt burdens. Geographic diversification across muni bond holdings is vital to reduce this risk.

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As previously stated

The municipal bond market funds local communities while offering investors unique benefits, especially tax-exempt income. However, traders must carefully weigh the risks around lower liquidity, complexity, and interest rate sensitivity inherent in these bonds. Doing proper due diligence on municipal bond holdings is important.

For investors who understand the municipal market and manage its risks, adding exposure to munis can provide excellent diversification. The tax-exempt yields on municipal bonds will exceed payouts from

Treasuries and corporate bonds for high-income earners. This makes municipal bonds a potentially valuable addition for investors in higher tax brackets looking to reduce their overall tax burdens.

Trader’s Tip: Always weigh the pros and cons before adding exposure to muni bonds in your financial portfolio. The key to successful trading is not just about chasing returns but also about understanding and managing potential risks. Stay informed, be diligent, and always keep your long-term objectives in mind when making investment choices.

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