What Are Municipal Bonds?

Jerome Cesarz is a senior investment consultant for Northwestern Mutual.

Bonds may not be the most exciting of asset classes, but there are many reasons you might choose to invest in them. Maybe you want to diversify your portfolio away from stocks or create some stability by investing in other than what is offered by more volatile types of investments. Or maybe you want to generate income from your portfolio without having to sell assets.

Whatever the case, bonds could be an effective way to help you reach those goals. There are several different types of bonds, each with its own risk/reward profile, that you may want to consider adding to your portfolio. Municipal bonds are one example.

Below, we’ll discuss municipal bonds—how they work—and answer other common investor questions. We also offer advice you can use to think about whether municipal bonds deserve a place in your portfolio.

What are municipal bonds?

A municipal bond, or muni, is a type of bond that is issued by a state, county or local government. When you buy a municipal bond, you are essentially lending money to whichever entity issued it in exchange for interest payments. This makes municipal bonds, like all other bonds, a type of fixed income investment that you can use to generate income.

How do municipal bonds work?

Municipal bonds work the same way as any other bond. The main difference is that they are issued by state, county and local (i.e., city and town) governments. When you purchase a municipal bond, you pay the principal to the bond’s issuer. Then, as long as you continue holding the bond, you will receive interest payments as outlined in the bond’s terms. If you hold the bond until it matures, you’ll get your principal back. Or, if you don’t want to hold the bond until maturity, you can sell it in the secondary bond market.

Who issues municipal bonds?

Municipal bonds can be issued by state, county and local (i.e., city and town) governments. They are often issued to fund a particular project—for example, to construct a highway or bridge, modernize a sewer system or expand a school—but they can also be used to fund the day-to-day expenses of whichever jurisdiction issued the bond.

When do municipal bonds pay interest?

Most municipal bonds pay interest semiannually, or every six months. Exceptions include:

• Some municipal bonds may pay interest once a year (annually)

• Very short-term bonds may just pay interest at maturity

• Bonds issued at a discount as a zero coupon bond involve no interest payments

The terms of the bond will outline when investors should expect interest payments.

Are municipal bonds fixed or variable rate?

The majority of municipal bonds carry a fixed interest rate, which means investors will receive the same interest payments over the life of the bond.

That being said, some munis, like variable rate demand obligations (VRDOs), do offer variable rates. These bonds most commonly target institutional investors, so you’re unlikely to come across them.

Are municipal bonds tax-free?

Usually you will not owe federal income taxes on the interest you receive from municipal bonds. And, if you live in the state that issued the bond, you likely won’t owe state income taxes on any interest you earn. There are few states that tax in-state bonds, so you will want to confirm that when you purchase.

But there are instances when you might end up owing some taxes on interest you receive from munis—for example, if you pay the alternative minimum tax (AMT) or if you invest in a municipal bond from a state that you don’t reside in.

A financial advisor can help you understand whether adding particular municipal bonds to your portfolio can help you minimize your tax burden.

How long does it take for municipal bonds to mature?

Just like bonds issued by businesses and the federal government, municipal bonds can be short term, intermediate or long term. Short-term munis will typically mature in less than a year, intermediate munis will typically mature within one to 10 years, and long-term munis typically take longer than 10 years to mature.

Are municipal bonds risky?

Among bonds, municipal bonds are usually considered:

• Less risky than corporate bonds, which are backed by individual businesses.

• More risky than Treasury securities, which have the full backing of the U.S. government.

Of course, all investments—even generally low-risk investments like municipal bonds—carry a certain level of risk. This is because there are many different types of investment risk that can affect your overall return. Some of the most relevant risks for munis are:

• Inflation risk: The risk that returns don’t keep pace with inflation, reducing your buying power.

• Interest rate risk: The risk that interest rates rise, reducing the face value of your bond if you were to need to sell it before it matures.

• Call risk: The risk that the issuer might call, or redeem, the bond and force you to find a new source of income. This only applies to callable bonds.

Types of municipal bonds

Municipal bonds come in two main varieties: revenue bonds and general obligation bonds.

Revenue bonds are tied to projects that are expected to generate revenue for the municipality. Some examples can include bonds that are issued to fund toll roads, public utilities (water, sewer, electric) and hospitals. Municipalities use a portion of the revenue that these projects generate to pay back bondholders.

General obligation (GO) bonds, on the other hand, are backed by the municipality itself, which typically pays bondholders back using a portion of tax revenue. They can be backed by the municipality’s general funds or specific property taxes, depending on the terms of the bond.

Of the two, revenue bonds are often considered riskier because a project might not generate as much revenue as expected. To attract investors, revenue bonds often offer higher yields than GO bonds.

How to invest in municipal bonds

If you’re interested in purchasing municipal bonds, you could do either of the following:

Buy individual municipal bonds

Going this route will require you to open a brokerage account, just like you’d use to invest in stocks. It will also require you to judge the merits of each bond yourself in order to determine whether the risk/reward aligns with your investing goals. And because most municipalities require a minimum commitment of $5,000 to invest in munis, you’ll need at least that much to invest.

Invest via municipal bond funds

If you don’t want the stress of evaluating individual munis or don’t have the minimum amount required to invest, you might consider investing via municipal bond funds, like an ETF or mutual fund. These funds invest in a wide variety of munis, offering you instant diversification and coming with much lower minimum investment amounts. Which bond fund you choose is up to your goals, but might include:

• National municipal bond funds, offering the greatest diversification.

• State-specific municipal bond funds, offering the greatest tax savings (to residents of that state).

• Short-term, intermediate, or long-term funds, offering different lengths of maturity that align with different investment timelines.

Are municipal bonds right for you?

To determine if municipal bonds are right for you, it’s important to understand your overall financial plan, goals and needs. Most portfolios have a blend of stocks and bonds based on individual investors’ goals and risk tolerance.

Municipal bonds could be an option if you’re looking to generate income without having to sell any assets while also minimizing your income taxes. They can also be a good choice for individuals with a strong sense of civic duty, who would like to directly and tangibly invest in the betterment of their home state or local area.

If municipal bonds make sense for you, we recommend you first start with a financial plan. Your Northwestern Mutual financial advisor can design you a personalized financial plan and help you evaluate your options and determine what role munis can play in a broader, diversified portfolio. They can help you see ways to protect and grow your wealth.

All investments carry some level of risk including the potential loss of principal invested. You should carefully consider risks with fixed income securities such as bonds, these include: Interest rate, Duration, Credit, Default, Liquidity and Inflation. Interest rates and bond prices tend to move in opposite directions, for example when interest rates fall, bond prices typically rise. This also holds true for bond mutual funds. A low interest rate environment may cause losses to bond prices and bond funds you own or in the market. Interest rates in the United States are at, or near historic lows, which may increase a Fund's exposure to risks associated with rising rates. High yield (Junk) bonds and bond funds that invest in high yield bonds present greater credit risk than investment grade bonds. No investment strategy can guarantee a profit or protect against loss.