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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When your state plans to undertake 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. Municipal and state governments will put a bond issue on the ballot, and voters in an election determine if bonds can be issued for the project. 

Investors can buy municipal bonds individually or invest in a municipal bond fund. Learn more about municipal bond funds, how they function, and the pros and cons of investing in them.

What Are Municipal Bond Funds?

State, county, and city government entities often take on debt to fund ongoing operations or large projects. The vehicle for this type of funding is called a “municipal bond.” 

If you purchase a municipal bond, you’re essentially lending the government money. Typically, you’ll receive interest payments twice a year along with the return of your original principal 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 Do Investors Earn Returns on Municipal Bonds?

The government uses its taxing power or revenue generation to pay back the bonds to investors with interest. General obligation bonds are paid back with taxes, and revenue bonds are paid back with revenue generated by the government. An example of a revenue-backed bond would be using highway tolls or express lane fees to return principal and interest back to the investors.

Instead of investing in individual municipal bonds, you can put your money in a municipal bond fund. Some bond funds spread their exposure across different types of bonds, such as municipal bonds, corporate bonds, or mortgage-backed securities. Others keep their assets in an exclusive category. 

Investors seeking tax advantages often buy municipal bonds. If you're considering doing the same, reach out to a tax professional to discuss the tax implications of any bond you're considering buying.

Pros and Cons of Investing in 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: Generally, the interest you earn from your investment in a municipal 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. Investors focused on a steady and reliable stream of income may want to look to municipal bond funds.

Steady rate of return: In general, municipal bond funds offer consistent and predictable returns over time. The returns may not be as high as more volatile investments like stocks, but they tend to outpace conservative products like certificates of deposit.

Historically low risk: While municipal bonds do come with some element of risk as almost all investments do, they are known to be a lower-risk investment choice because they have a specified maturity date and are designed 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: Municipal bond funds tend to pay lower yields than other types of bond funds. While a municipal yield might be lower than other bond investments, the “after-tax yield” can be higher. Do the math or consult your financial adviser to see if a municipal bond fund’s tax-free status offsets the relatively lower yield. If you’re in a higher tax bracket, municipal 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 are not obligated to pay the bond holder if the revenue stream the government intended to use to pay back the investor dries up (e.g., a state experiences a drastic decrease in toll revenue during a pandemic).

Credit risk: While municipal bonds are not considered high risk, a few publicized incidences of cities or counties not being able to pay back bondholders have occurred. Just as you would scrutinize a country when trading its currency or company when buying its stock, consider the financial health of the state, city, or county issuing a municipal 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 prematurely, you might not receive all the interest you expected. An entity might do this when interest rates drop below the interest rate the bond offers to save money on interest payouts.

In a rising interest rate environment, municipal bond share prices tend to fall. An atmosphere of decreasing rates can put a drag on municipal bond interest income.  

How to Buy Municipal Bond Funds

You can purchase municipal bond funds just as you would other investment vehicles—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 municipal bonds via an exchange-traded fund (ETF). As with any other ETF, check on the fund’s fee structure to understand how much your expenses will eat into your profit.

To see how municipal 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

  • Government entities offer municipal bonds to fund infrastructure and other projects. You can buy individual municipal bond funds or purchase municipal bond funds that contain a collection of different muni bonds. 
  • While municipal bonds tend to offer lower yields than other types of bonds, you will generally not have to pay federal taxes (or possibly state and local taxes) on them, making the after-tax return attractive, particularly for investors in a higher tax bracket. 
  • Municipal 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, which is the income you can expect to generate from your investment.
  • You can purchase municipal bond funds or ETFs directly through your broker or bank, just as you do individual stocks, mutual funds, and stock ETFs.