Many municipalities and local governments are tasked with providing public services like water, sewer, streets, libraries, and more.
While taxpayers cover the ongoing cost of these services, the large upfront cost to install a new facility, like a sewer treatment plant, is often more than a local government can front. That funding gap is addressed by the government issuing bonds, which fall under an IRS classification permitting exemption from federal tax.
Municipal bonds, commonly referred to as “munis,” are debt securities issued by states, cities, counties, or other governmental entities to finance public projects such as schools, highways, water systems, and other infrastructure. 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, 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, since the after-tax yield often surpasses that of taxable bonds or savings accounts — a dynamic worth understanding alongside other tax-advantaged structures like REITs.
Depending on an investor’s home state, it may or may not make sense to stay within their state of issuance. State tax burden varies widely, and for those in states with little to no state income tax, staying within your home state may offer little added benefit. In a high-tax state, however, the state tax exemption becomes 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 principal at maturity, making them a popular choice for conservative investors and those nearing retirement who want 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’re directly aware of the investment happening in our local community, and munis can be an attractive way to support that infrastructure directly.
Types of Municipal Bonds
Municipal bonds fall into two primary categories:
- General Obligation Bonds (GOs): Backed by the full faith and credit of the issuing municipality, meaning they’re 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: Secured by specific revenue streams, such as tolls, water bills, or hospital fees. These may offer higher yields, but carry slightly higher risk since repayment depends on the success of the funded project.
Key Considerations for Municipal Bond Investors
- Credit risk: Though municipal bonds are generally low-risk, they’re not entirely risk-free. Investors should assess the creditworthiness of the issuer, which varies depending on the municipality’s financial health.
- Interest rate sensitivity: Like all bonds, municipal bonds are sensitive to interest rate fluctuations. When rates rise, bond prices typically fall — a risk worth weighing, especially if you plan to sell before maturity.
- Call provisions: Some municipal bonds allow the issuer to repay the bond before maturity. This can benefit issuers during periods of falling rates but may leave investors with reinvestment risk if they can’t find similar yields elsewhere.
- Liquidity: While munis are a popular investment, they can be less liquid than Treasury or corporate bonds, particularly in smaller markets. Investors should be comfortable holding the bond until maturity, or accept the potential for less favorable pricing when selling early.
How to Invest in Municipal Bonds
- Individual bonds: Investors can purchase municipal bonds through brokers, directly from issuers during new offerings, or in the secondary market. Buying individual bonds allows investors to select specific issuers or projects that align with their goals.
- Municipal bond funds: For those who prefer diversification and professional management, municipal bond mutual funds or ETFs offer exposure to a broad range of municipal bonds, spreading risk across multiple issuers and projects, though they typically charge management fees.
Conclusion
Municipal bonds can be a valuable addition to a diversified investment portfolio, offering tax advantages, steady income, and relative safety — a useful complement to other tax-aware strategies real estate investors already track, like recent federal tax changes.
By investing in bonds, you become a part of the infrastructure supporting your local economy, which benefits all real estate investors in that community.
Many investors we serve benefit from an active approach that keeps after-tax return in mind. Call us today to review your real estate strategy.
