Should You Invest in Municipal Bonds?

Municipal bond interest is exempt from federal income tax and also from state and local taxes if the bond was issued in your state of residence. — Photo by Gallery Stock

En español  |  Municipal bonds tend to rank high on the list of investments that financial planners recommend to people who are nearing — or who’ve reached — retirement. They’re known for their relative safety and generous tax breaks and, perhaps most importantly, for preserving capital.

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But “munis,” as they’re commonly known, have exhibited some uncharacteristic swings in recent years, raising questions about how safe they really are. The consensus among financial planners is that the bonds remain a good option for older investors, as long as you do your homework.

Here are answers to 9 common muni questions.

1. So just what are municipal bonds?

They’re essentially IOUs issued by state or local governments, government agencies and sometimes private companies that are working on projects with governments. There are two types of munis. General-obligation bonds finance basic government operations and are repaid from tax revenue. Revenue bonds, however, pay for specific projects such as power plants or sewage treatment facilities. The project’s eventual revenue — electric bills, bridge tolls and so on — goes to cover repayments.

2. How do you make money with them?

Munis typically have fixed interest rates, so you receive identical income payments, usually every six months, until the bonds reach maturity and principal is repaid. Maturities generally range from one year to 30 years, though some go even longer.

Bonds with longer maturities tend to pay higher rates because their prices in resale markets are more sensitive to fluctuations in interest rates and inflation. The higher rates in munis are a way of compensating you for accepting greater volatility, which means a higher risk of loss if you need to sell your bonds before maturity.

3. How or where do you buy munis?

You can buy single municipal bonds, which come in minimum denominations of $5,000. Another option that’s likely less volatile is mutual funds that hold many different muni issues. Single bonds and shares in funds alike can be bought through brokerage firms, just like stocks. At discount brokerages it’s often possible to buy mutual funds without paying a commission.

4. How is muni income taxed?

Very lightly. Municipal bond interest is exempt from federal income tax and also from state and local taxes if the bond was issued in your state of residence. That means you end up with more money in your pocket than if you held taxable bonds, such as Treasuries, or corporate bonds that pay the same interest rate.

These tax breaks can be especially useful if you’re an older investor — you may well have fewer tax deductions than younger taxpayers and rely more on interest income for your living expenses.

Next: Are there any risks involved with munis? »