Municipal bonds are generally understood as mutually beneficial for both issuer and holder—they allow cities to secure capital for local projects while providing investors with tax-free income. These bonds, also known as munis, are issued by state and local governments, as well as government agencies, and are typically used to finance public works projects such as schools, highways, and hospitals.
One of the key benefits of investing in municipal bonds is their tax-free status. The interest income earned on these bonds is exempt from federal income tax, and in many cases, state and local taxes as well. This can be especially beneficial for investors in higher income tax brackets, as it allows them to keep more of their investment returns.
Another advantage of municipal bonds is their relatively low default rate. According to Moody's Investors Service, the default rate for municipal bonds from 1970 to 2019 was only 0.17%. This is significantly lower than the default rate for corporate bonds, which was 3.55% over the same period.
However, like any investment, municipal bonds do carry some risks. One of the biggest risks is interest rate risk. When interest rates rise, the value of existing bonds decreases, which can lead to losses for investors who wish to sell their bonds before they mature. This risk can be mitigated by investing in bonds with shorter maturities, as these are less sensitive to changes in interest rates.
Another risk to consider is credit risk. While municipal bonds are generally considered to be low-risk investments, there is always the possibility that the issuer may default on its obligations. To minimize this risk, investors should do their due diligence and research the creditworthiness of the issuer before investing.
In addition to these risks, municipal bonds also face regulatory challenges. The CDA system for municipal securities registration works, but is cumbersome. Exemption exists from CDA requirement in Rule 15c2-12 for limited offerings, but this exemption is not available for new issues of bonds. This can make it difficult for smaller issuers to access the municipal bond market.
Despite these challenges, municipal bonds remain a popular investment choice for many investors. The rate on the more than $100 billion of municipal money-market funds can be volatile, but these funds still offer a relatively safe and stable investment option.
In fact, two new funds from Vanguard and Goldman Sachs Asset Management are expanding investors' options for municipal bond bets. These funds offer exposure to a range of maturities and credit qualities, allowing investors to tailor their investments to their specific needs and risk tolerance.
However, investor concerns over the crises within the financial industry are bleeding into a corner of the $4 trillion municipal-bond market where some investors are worried about defaults by cities and states. While these concerns may be valid, it is important to remember that municipal bonds have historically had low default rates, and that the vast majority of issuers have strong credit ratings.
Ultimately, investing in municipal bonds can be a smart choice for investors who are looking for a relatively safe and stable source of income. By doing their due diligence and carefully considering the risks and benefits, investors can make informed decisions about whether municipal bonds are the right choice for their portfolios.
