Many municipalities and local governments are entrusted with providing public services and infrastructure such as water, sewer, roadways, libraries, bridges, and more.
While taxpayers cover the burden of these costs over time, the large upfront cost is often more than a local government can front. The government addresses this money constraint by issuing bonds for investors to purchase. These bonds fall under an IRS classification that permits them to be exempt from federal taxes.
Municipal bonds, commonly referred to as “munis”, are debt securities issued by cities, counties, states, or other government entities to finance public projects. For investors seeking a relatively low-risk investment with tax advantages, municipal bonds can be a compelling option.
Why Invest in Municipal Bonds?
1. Tax Advantages
One of the most significant benefits of municipal bonds is their tax-exempt status. Interest income earned on most municipal bonds is exempt from federal income tax and, in many cases, is also exempt from state and local taxes if the investor resides in the issuing state. This tax advantage makes munis particularly attractive to individuals in higher tax brackets, as the after-tax yield often surpasses that of taxable bonds or savings accounts.
The map below shows each state’s income tax burden. For those in states with little to no state income tax, it may offer you no benefit to limit your municipal bond investing to your home state. However, if you’re in a high-tax state such as NY, the state tax exemption is an important consideration.
2. Stability and Predictable Income
Municipal bonds are considered relatively low-risk investments. They offer a fixed interest payment (coupon) at regular intervals and return the principal at maturity, making them a popular choice for conservative investors and those nearing retirement who seek a steady income stream.
3. Support for Local Communities
Investing in municipal bonds allows individuals to directly support projects that benefit their local community, such as upgrading public schools, improving transportation systems, or enhancing public utilities.
As real estate investors, we are acutely aware of the effect that investing in a community can have. Munis can be an attractive way to support their infrastructure and encourage growth.
Types of Municipal Bonds
Municipal bonds are categorized into two primary types: general obligation bonds and revenue bonds.
General Obligation Bonds (GOs)
These bonds are backed by the full faith and credit of the issuing municipality, meaning they are supported by the issuer’s taxing power. GOs are often considered safer because they rely on the issuer’s ability to collect taxes, rather than revenue from a specific project.
Revenue Bonds
Revenue bonds are secured by specific revenue streams, such as tolls, water bills, or library fees. While they may offer higher yields, they carry a slightly higher risk since repayment depends on the success of the funded project.
Key Considerations for Municipal Bond Investors
1. Credit Risk
Though municipal bonds are generally low-risk, they are not entirely risk-free. Investors should assess the creditworthiness of the issuer, which can vary depending on the municipality’s financial health.
2. Interest Rate Sensitivity
Like all bonds, munis are sensitive to interest rate fluctuations. When interest rates rise, bond prices typically fall. Investors should consider this risk, especially if they plan to sell their bonds before maturity.
3. Call Provisions
Some municipal bonds come with call provisions, allowing the issuers to repay the bond before its maturity date. While this can be advantageous for issuers during periods of falling interest rates, it may leave investors with reinvestment risk if they cannot find similar yields.
4. Liquidity
While munis are a popular investment, they can be less liquid than Treasury bonds or corporate bonds, particularly in smaller markets. Investors should ensure they are comfortable holding the bonds until maturity or accept the potential for less favorable pricing when selling.
How to Invest in Municipal Bonds
1. Individual Bonds
Investors can purchase municipal bonds through brokers, directly from issuers with new offerings, or in the secondary market. Buying individual munis allows investors to select specific issuers or projects that align with their goals.
2. Municipal Bond Funds
For those who prefer diversification and professional management, municipal bond mutual funds or exchange-traded funds (ETFs) offer exposure to a broad range of municipal bonds. These funds spread the risk across multiple issuers and projects, but often charge management fees.
Conclusion
Municipal bonds can be a valuable addition to a diversified investment portfolio, offering tax advantages, steady income, and relative safety.
By investing in bonds, you can be a valuable part of the infrastructure for your local economy, which benefits all real estate investors.
We believe in investing with a proactive approach, keeping your after-tax return in mind to maximize your profits. Call us today to review your real estate investment strategy.
Sources
https://www.schwab.com/learn/story/when-to-choose-munis-from-outside-your-home-state
https://www.investopedia.com/ask/answers/why-interest-rates-have-inverse-relationship-bond-prices
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