Municipal bonds

What are municipal bonds?

Municipal bonds, known as munis, work like loans. State and local governments or special authorities issue munis to fund public building projects or updates to schools, highways, sewers and hospitals. When you buy munis, you lend money through the bond to the city, county, state or school district.

The issuer takes the money — often starting at $5,000 and increasing by $5,000 increments thereafter — and makes regular interest payments to you until you receive the entire principal back at the end of the bond’s term.

Are municipal bonds taxable?

Federal taxes don’t apply to the interest income from municipal bonds. That interest may also be exempt from state and local taxes if you live where the bond was issued, so you may never owe income taxes on bond earnings. However, the interest may be subject to the alternative minimum tax (AMT).

Overall, earning tax-free income through munis may make sense if you’re planning to preserve every dollar possible in retirement. But it’s a good idea to compare taxable bond interest rates, since you may earn more with taxed bonds than tax-advantaged ones. Still, the after-tax return of an out-of-state bond may not be too different from that of a bond from your own state.

Types of municipal bonds

The borrowing municipality can pay back the principal plus interest by using taxes or revenue. This means municipal bonds often fall into one of two general types: 

• Tax-backed municipal bonds or general obligation bonds

The municipality pays back these types of bonds with city, county or state tax revenue. For example, a bond issued to build your city’s new high school would be tax-backed because the school district promises to pay you back with resident property taxes. You may even see general obligation bond issues appear on your local election ballot, since many municipalities let residents vote on bonds that could raise their taxes.

• Revenue-backed or revenue bonds 

Municipalities may issue revenue bonds to improve a good or service residents pay for, such as a utility. For example, a bond issued to improve the local water system would be paid off with the money citizens pay toward their water bills.

Municipal bond investment strategies

These three investment strategies could help you achieve reliable, low-risk income from municipal bonds, especially in retirement.

The quality bond approach
Since higher-quality bonds have a lower default risk, we recommend 85% of your fixed-income portfolio be composed of bonds rated AAA, AA or A. Though bonds with a BBB rating are investment-grade quality, they should make up only a small portion of your portfolio. 

The bond diversification method
You should strive to diversify your fixed-income investments by issuer and category.  Owning bonds from a variety of issuers can help reduce overall risk. Work to ensure that no single obligor – the issuer making interest and principal payments – makes up more than 5% of your total investment portfolio.

Three primary categories of bonds are:

1. Government
2. Corporate
3. Municipal

Owning bonds across categories can help balance bond credit quality and your income needs.

Making sure your bonds aren’t all from one state or region can also help you reduce risk. In some cases, depending on your tax rate and current market conditions, the after-tax return of an out-of-state bond may not be too different from that of a bond from your own state. In that case, it may be a good strategy to accept a slightly lower rate to diversify into bonds from other states. 

If you’re looking for current income, work with your financial advisor to determine which types and amounts of bonds are appropriate for you. Diversification is key in helping ensure your portfolio can weather any market ups and downs. Keep in mind, however, that diversification does not guarantee a profit or protect against loss in a declining market.

The long-term investment strategy
We recommend buying bonds with the intention of holding them until they mature or are redeemed by the issuer. Bonds can provide interest payments and a return on principal. Although it can be tempting to time the market as interest rates and bond prices change, we believe you should buy bonds for the current income they provide.

Where are municipal bond interest rates going?

Understanding how municipal bond interest rates vary can help you make an informed choice before buying:

• Interest rates change in general, and when they rise, bond prices usually fall.
• Interest rate risk refers to the risk involved in a lowered bond value.
• Since interest rates and bond prices may move in opposite directions, your bonds’ market value could vary over time, even though the income they earn stays constant.

Instead of trying to predict exact interest rate movements, we here at Edward Jones recommend bond laddering to help you combat rising rates. Laddering staggers the maturity dates of your fixed-income investments to own a mix of short-, intermediate- and long-term bonds. 

Your financial advisor can help you lower interest rate risk by finding and laddering a variety of bonds with staggered maturities within Edward Jones' sizable inventory. 

You also can keep up-to-date on the fixed-income market by reading our monthly fixed-income focus.

^{Source: Bloomberg.}

As shown in this chart, municipal bond interest rates have fluctuated widely over time.

Current municipal bond interest rates

Stay informed about current rates for municipal bonds, certificates of deposit (CDs) and money market accounts (MMAs).

How to buy municipal bonds

Buying municipal bonds with Edward Jones can enhance your personalized investment strategy, diversify your portfolio and help you achieve your long-term investing goals.

Here’s how we can help you buy low-risk municipal bonds: 

• Our market analysts conduct a rigorous review to ensure municipal bonds meet our established guidelines.
• The bonds must then pass our credit review.
• Once the bonds are approved, we make the municipal bonds available to our investors.

Work with an Edward Jones financial advisor today to take advantage of tax-free municipal-bond income.