These bonds offer tax-exempt income and high credit quality, making them an option for income-oriented investors looking to reduce federal and, possibly, state income tax bills.
Municipal bonds offer tax-exempt income and high credit quality, making them an option for income-oriented investors looking to reduce federal and, possibly, state income tax bills.
What are municipal bonds?
Municipal bonds are issued by state and local governments to fund public projects for building or improving things like schools, highways, sewers, airports and hospitals. Often, municipal bonds are issued by special authorities specifically created for that purpose.
Municipal bonds are federally tax-free and, in some buying a bond is basically extending a loan to a "borrower." In the case of municipal bonds (also known as "muni bonds"), the borrower is a city, county, state or school district. The municipality borrows the money (usually a minimum of $5,000 and going up in increments of $5,000 from there), and the bond holder receives fixed payments from the city or state usually twice a year. Then, at the end of the loan term, the borrower pays back the principal.
Are municipal bonds taxable?
Interest income from municipal bonds is exempt from federal income tax. In addition, municipal bonds issued within your state may be exempt from state and local taxes. It’s important to keep this in mind when looking at municipal bond rates. In order to accurately compare taxable bonds and tax-free municipal bond rates, you must look at the taxable-equivalent yield.
Municipal bonds are federally tax-free and, in some cases, are free from state and local taxes too. That means, depending on where you live, you may never owe income taxes on the payments you receive from the bond's issuer (but they may be subject to the alternative minimum tax or AMT). When you retire, your portfolio returns might be lower because you're taking less risk and your health care expenses may be higher because you're older. Getting tax-free income may make sense so you can preserve every dollar possible.
Backed by taxes or backed by revenue
To pay back the interest and principal on a bond, the borrowing municipality can raise the funds one of two ways: either using taxes or using revenue. This informs what type of muni bond the issue will be.
- Tax-backed – When a municipality uses taxes to pay back the debt, the bond is called a "general obligation bond." This just means it's backed by the taxing power of the issuing city, county or state. For example, a bond that is being issued to build a new high school would probably be a general obligation bond because the town where that school is located is "obligated" to back the loan. The residents' property taxes will make up the funds that are used to pay the interest and principal. You may be familiar with bond issues on your local election ballots. Many municipalities let voters decide yes or no on bond issues because ultimately, the bond issue will raise the citizens' taxes.
- Revenue-backed – The other type of bond is called a "revenue bond." A bond that is issued to improve a local water system would be one example of this kind of bond. The citizens' water bills would be used to operate and maintain the water system and that revenue would then go toward the bond's interest and principal payments.
Investing in municipal bonds
When investing in municipal bonds, or bonds in general, you should be better positioned to achieve reliable income, less principal fluctuation resulting in reduced portfolio risk, by focusing on three investment principles.
- Quality Bonds
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.
- Bond diversification
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 government, corporate and 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.
- Long-term Investing
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?
At Edward Jones, instead of trying to predict exact interest rate movements, we recommend a strategy called "bond laddering" to help you combat the potential for rising rates. Laddering means staggering the maturity dates of your fixed-income investments to own an appropriate mix of short-, intermediate- and long-term bonds.
The income you receive from muni bonds you've purchased will stay the same, but the market value of the bonds will vary over time. Bond prices and interest rates move in opposite directions like a teeter-totter, so when interest rates rise, bond prices fall. The risk of this lowering of bond values is called "interest rate risk." Your financial advisor has access to Edward Jones' sizable inventory of municipal bonds. He or she can help you build a bond ladder by finding a variety of bonds with staggered maturities. Owning short-, intermediate- and longer-term bonds can help you avoid playing guessing games with interest rates, and you'll have a more diversified portfolio – which can help lower your interest rate risk.
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How to buy municipal bonds
Our market analysts conduct a rigorous review and approval process before making municipal bonds available to our investors. Municipals bonds must meet our established guidelines and pass our credit review. Buying municipal bonds as part of a well-diversified portfolio, can help investors achieve their long-term investing goals. Working with an Edward Jones financial advisor, we'll work with you to create that personalized investment strategy, to help you get there.
Before investing in bonds, you should understand the risks involved, including credit risk and market risk. Bond investments are also subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease, and the investor can lose principal value if the investment is sold prior to maturity.
You must evaluate whether a bond or CD ladder and the securities held within it are consistent with your investment objectives, risk tolerance and financial circumstances.
Diversification does not guarantee a profit or protect against loss in declining markets.