Why Invest in Municipal Bond Funds?

Pros and Cons of Investing in Government Projects

An investor looks over her muni bond fund performance.
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 Oscar Wong / Getty Images

When your state embarks on a major infrastructure project or your city needs to upgrade public buildings or the sewer system, they may need to raise money for these projects. To pay for the upgrades, cities, counties, and states will put a bond issue on the ballot. It is the voters who decide if bonds can be issued for the project. 

You can buy municipal bonds on their own or invest in a municipal bond fund. Learn more about muni bond funds, how they function, and the pros and cons of buying them.

What Are Municipal Bond Funds?

State, county, and city governments often take on debt to fund normal operations or large projects. The way they get the funds to pay for the projects is through municipal bonds

If you purchase one of these bonds, it's like you're lending the city, county, or state money. Most of the time, you’ll receive interest payments twice a year along with the return of the original amount of your investment at the bond’s maturity. This time frame can range from one to three years for short-term bonds to more than a decade for long-term bonds. 

How Are Returns Earned on Municipal Bonds?

The government uses its taxing power or revenue generation to pay back the bonds with interest. General obligation bonds are paid back with taxes, and revenue bonds are paid back with money raised by the government. For instance, a revenue-backed bond would be using highway tolls or express lane fees to return principal and interest back to people who bought the bonds.

Instead of investing in muni bonds on their own, you can put your money in a muni bond fund. Some bond funds spread their exposure across a range of bonds, such as muni bonds, corporate bonds, or mortgage-backed securities. Others keep their assets in one category. 

People seeking tax advantages often buy muni bonds. If you're thinking about doing the same, reach out to a tax expert to discuss the tax impacts of any bond you're thinking about buying.

Pros and Cons of Getting Into Municipal Bond Funds

Pros
  • Tax advantaged

  • Steady rate of return

  • Historically low risk

  • Diversification

Cons
  • Lower yield

  • Non-recourse bonds

  • Credit risk

  • Call and interest-rate risk

Municipal Bond Pros Explained

Tax advantaged: In most cases, the money you earn from a muni bond or bond fund is exempt from federal taxes. If you live in the state where the bond was issued, you might also be off the hook for state and local taxes. If you want a steady and reliable stream of income, you may want to look to muni bond funds.

Steady rate of return: Most of the time, muni bond funds offer steady and certain returns over time. The returns may not be as high as more risky investments like stocks, but they tend to outpace conservative products like CDs.

Low risk over time: While muni bonds do come with some risk as almost all investments do, they are known to be a lower-risk choice because they have a set maturity date and are made to protect the principal investment.

Diversification: Investors who have high-risk investments such as company stocks may wish to include municipal bonds in their investments to balance and diversify their portfolio.

Municipal Bond Cons Explained

Lower yield: Muni bond funds tend to pay lower yields than other types of bond funds. While a municipal yield might be lower than other bonds, the “after-tax yield” can be higher. Do the math or consult your financial adviser to see if a muni bond fund’s tax-free status offsets the lower yield. If you’re in a higher tax bracket, muni bond funds might make sense to you if you have high long-term capital gains and are subject to net-investment income tax rates.

Non-recourse bonds: Some revenue-backed bonds do not have to pay back the bond holder if the revenue stream the government meant to use to pay back the investor dries up (e.g., a state has a drastic decrease in toll earnings during a pandemic).

Credit risk: While muni bonds are not thought to be high risk, a few instances of cities or counties not being able to pay back bondholders have occurred. Just as you would take a close look at a country when trading its currency or company when buying its stock, look at the financial health of the state, city, or county issuing a muni bond you’re looking at buying.

Call and interest-rate risk: If the bond issuer repays its obligation before a bond’s maturity date by "calling" or “redeeming" it early, you might not receive all the interest you thought you would. An entity might do this when rates drop below the interest rate the bond offers to save money on interest payouts.

When interest rates are rising, muni bond share prices tend to fall. Decreasing rates can put a drag on muni bond interest income.  

How to Buy Municipal Bond Funds

You can purchase muni bond funds just as you would other investments, via your broker or a bank. You’ll buy shares of the bond fund just as you would a mutual fund that holds stocks. 

You can also invest in muni bonds via an exchange-traded fund (ETF). As with any other ETF, check on the fund’s fee structure to see how much your costs will eat into your profit.

To see how muni bonds perform over time, check an index that tracks them. The S&P Municipal Bond Index is a good place to start. As of April 2021, the one-year return of this index stood at 6.69%.

Key Takeaways

  • Governments offer municipal bonds to fund infrastructure and other projects. You can buy muni bonds or purchase muni bond funds that contain an array of muni bonds. 
  • While these bonds tend to offer lower yields than other types of bonds, in most case you won't have to pay federal taxes (and maybe state and local taxes) on them.
  • Muni bond funds present less risk than other similar investments, but they’re not without risk.
  • Interest rates impact bonds. Rising rates can hit a bond fund’s share price while decreasing rates can reduce yield.
  • You can purchase muni bond funds or ETFs through your broker or bank, just as you do individual stocks, mutual funds, and stock ETFs.