The basics of municipal bonds

Insights from Morgan Stanley Wealth Management

08/17/21

Summary: Municipal bonds, like other bonds, can provide investors with fixed income payments and capital preservation—but it’s their tax advantages that investors are often most curious about. Learn what to consider when investing in municipal bonds.

Bonds play a key role in a comprehensive investing strategy, as they provide a generally reliable source of income, capital preservation, and a way to diversify portfolios, among other advantages.

Municipal bonds, specifically, can offer investors additional benefits, including the ability to invest in local projects that may directly impact their communities. Perhaps most notably, many investors look to “munis” for their tax advantages since the interest is typically exempt from federal income tax.

Not all munis are tax free, though, so it is important to understand the landscape. We highlight key considerations when investing in municipal bonds.  

Munis 101

Municipal bonds are issued by state and local government entities to help fund the development, maintenance, and management of a public works project (think construction of schools, hospitals, essential transit, and utility systems). Issuers include states, counties, cities, school districts, universities, hospitals, utilities, airports, and many other non-federal governmental entities.  

When a municipal bond is purchased, the bondholder has essentially loaned money to a public issuer in exchange for a set number of interest payments over a specified timeframe. Once the bond is called or reaches its maturity date, the investor typically receives the full amount of the original investment. The source of these interest and principal payments is what distinguishes the two main categories of municipal bonds:

General obligation bonds Revenue bonds
General obligation (GO) bonds are the most common type of municipal security and usually finance projects that benefit the community, like public schools or parks. GO bonds are often backed by an issuer’s “full faith and credit,” where the state or local government pledges its taxing authority to repay the bonds. Revenue bonds are often issued by public entities to fund the creation, maintenance, expansion, and ongoing management of revenue-generating projects. These can include essential-service water, sewer, and public utility systems, roadways, transit networks, and transportation hubs (such as airports). Principal and interest payments are generally paid by the revenues generated by the system or funded project.

GO and revenue bonds can also be insured or pre-refunded. Insured bonds carry an assurance that’s pledged to pay interest and principal (as it comes due) if an issuer defaults on an obligation. Pre-refunded bonds tend to be redeemed before their maturity date. In these cases, the interest and principal payments have already been raised and are held in escrow until the issuers can legally call the bonds. The bonds typically trade at premium prices and offer less yield than other securities, since the investments are often considered to be among the market’s highest quality.

Tax advantages

Notably, municipal bonds provide income-tax exemptions that other fixed income securities don’t. This can be especially useful for reducing the tax burdens for investors in higher tax brackets. Depending on the municipal bond, the interest may be free from federal, state, or local taxes—or all three.

Federal taxes Interest on municipal bonds is exempt from federal income tax.
State and local taxes Interest on municipal bonds may not be taxed by the government within which it was issued. For example, New York State does not tax the interest on a municipal bond issued in New York.
Triple tax exempt Municipal bonds that are issued in a city where an individual is taxed may be exempt from city, state, and federal income taxes. Where this tax treatment is applicable, the bonds are known as “triple tax exempt.”
Capital gains taxes Bonds sold for a higher price than they were purchased may be subject to federal and state capital gains taxes.
Taxable municipal bonds These bonds are not exempt from federal income taxation, often because the proceeds do not provide a direct or significant benefit to the public. One example is the Build America Bonds (BABs) program, in which state and local governments issue federally taxable municipals to attract capital from non-traditional buyers, such as non-US investors that typically do not benefit from the federal exemption.

Online tools like E*TRADE’s Taxable Equivalent Yield Calculator can help investors determine comparable yields on specific taxable and tax-exempt bonds by using their personal tax requirements. Depending on an individual’s tax bracket, a tax-exempt municipal bond with a lower yield may offer a higher after-tax return than a higher yielding taxable bond.

Investors should be aware that some municipal bonds may be subject to an additional “alternative minimum tax,” or AMT. This might be the case for a bond issued to support a project that provides both public and private benefits.

Additional considerations

Investors may also want to consider what type of account they are using to help maximize the potential benefits of municipal bonds. For example, since retirement accounts like IRAs, provide tax efficiencies for all securities, a brokerage account may offer investors a better way to take advantage of munis’ tax treatment.

Keep in mind that the minimum investment for municipal bonds is higher than other fixed-income assets like corporate bonds. Munis are typically issued in denominations of $5,000, whereas corporate bonds may be offered for $1,000. 

Finally, while municipal bonds are generally considered low risk based on their history of strong creditworthiness, as with all investments, there are still potential risks. There is the possibility that an issuer may not pay interest and/or principal payments on a timely basis. Rising interest rates also present challenges, since, all else equal, bond prices fall if interest rates rise (and vice versa). Bonds with longer maturities tend to be more sensitive to interest rate risk than those with shorter ones. Also, if an investor sells their bond before maturity there is a risk they may receive an amount below purchase price or par value. This may be caused by demand, interest rates, and other factors.

 

 

The source of this article, Building the Nation - A Simplified Guide to Municipal Bond Investing, was originally published on February 25, 2021.

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