What Are Municipal Bonds?

Learn how to utilise Municipal Bonds as part of your investment portfolio and how they're different from other kinds of trading assets.

Updated: May 20, 2024
Matt Crabtree

Written By

Matt Crabtree

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Whether you're new to investing or a seasoned pro, it helps to know what kinds of investment options you've got available to you outside the more obvious picks like stocks or crypto.

So, throughout this article, we're going to break down all you need to know about municipal bonds and why you should consider including them in your trading portfolio.

Understanding Municipal Bonds

You'll probably hear municipal bonds referred to as “munis” more often than not if you're someone who likes to linger on trading forums or the financial side of Twitter, but in essence, these are basically just debt securities that are issued by governmental entities in order to fund a bunch of different public projects — whether they're schools, roads, bridges, or any other kind of expenses our taxes usually go towards.

Now, there's a key difference between something like this and corporate bonds, as you'd generally only ever see the latter be issued by private companies in order to raise capital for their own business.

Municipal bonds, on the other hand, are typically issued by national or local governments, but certain agencies and authorities issue them too, and you won't always go directly to the gov to receive one — they're available on secondary markets also.

Types of Municipal Bonds

Let's take a look at the two main kinds of municipal bonds you can invest in:

General Obligation Bonds

These bonds are backed by the full faith and credit of the issuer, which basically means that the issuing municipality pledges its resources (which includes its ability to raise taxes) in order to repay you.

This is a kind of guarantee you'll generally see few and far between in the trading world, so general obligation bonds are typically considered one of the safest types of munis because of this.

Revenue Bonds

In contrast, revenue bonds derive their repayment from the revenue that's generated by a specific project or source, such as tolls from a bridge or fees from a utility service, meaning that the viability of revenue bonds hinges on the success and profitability of the underlying project. 

Benefits of Municipal Bonds

Obviously, you're not exactly short of choice in terms of the range of assets you can invest in as a trader, so what makes municipal bonds so special?

Tax-Free Income

One of the most significant (and unique) benefits of munis is the fact that any of the interest income they generate is usually exempt from any kind of federal income tax, making them pretty attractive to people in higher tax brackets since they enhance your overall after-tax return.

Stability and Safety

Municipal bonds are generally considered fairly low-risk investments — particularly if we're talking about general obligation bonds that are backed by the taxing authority of the issuer. 

Now, this stability isn't everyone's cup of tea, especially if you're used to insanely volatile markets like cryptocurrency, but you'd definitely find some respite here if you'd rather have a more predictable income stream.

Risks Associated With Municipal Bonds

While municipal bonds are generally considered one of the safer investments out there, they're certainly not entirely without risk:

Interest Rate Risk

Like all fixed-income securities, municipal bonds are susceptible to changes in interest rates, which basically means that as interest rates rise, the value of your existing bonds might decline, which can lead to potential capital losses if you sell them before maturity.

Credit Risk

Although general obligation bonds are backed by the taxing authority of the issuer, revenue bonds rely on the revenue generated by specific projects. As such, if these projects aren't able to generate sufficient revenue, bondholders may face the risk of default.

The Municipal Securities Rulemaking Board's Responsibilities

Like pretty much any kind of loan or bond — not even just the ones you're given by the government — it's obviously paramount that there's a certain level of transparency and fairness maintained towards whoever's receiving the loan, which is where entities like the Municipal Securities Rulemaking Board (MSRB) come into play.

In the simplest of terms, the MSRB is basically just a regulatory watchdog that makes sure there's no wrongdoing or anything shady about how broker-dealers or banks treat you while either issuing or trading municipal securities — so the main idea is here is essentially just promoting integrity so relatively defenceless (at least in comparison with the stature of the people giving you the bond) investors like yourself aren't being mistreated.

Electronic Municipal Market Access (EMMA)

Now, there are a bunch of different ways they try to ensure fairness, but one of the main ways is through something called the “Electronic Municipal Market Access (EMMA) system“, which is basically a hub for key information about municipal securities so ordinary people can see things like the bond issuance details and disclosure documents.

Without this, you're probably going to be way more confused when trading in this market, so you're definitely getting a level of transparency here that levels the playing field a little bit.

Having said that, the MSRB isn't really designed solely to set rules and provide information that you'd otherwise be able to find with more research; it's also about making the industry a generally more collaborative place since it deals with both market participants and the policymakers themselves.

Because of this, the MSRB can spot any kind of issues that arise and work with the relevant people to develop regulatory solutions, making them not just regulators but general proponents of a marketplace that's actually fair for everyone involved.

Naturally, enforcement still plays a pretty big part in this, so you'll often read about how the MSRB monitors market activity and investigates any potential violations of securities laws — and as a result, bad actors can actually be held accountable for their actions and people like you, the investors, are protected from harm.

Investing in Municipal Bonds

While they're probably not the average retail investor's first choice when they're thinking about getting into investing, it's fairly understandable why you'd want to look into municipal bonds if you're interested in diversifying your portfolio given how lucrative they are (especially if you're someone who's trying to get around paying federal taxes like you would with any other kind of investment).

We've already identified a few of the main risks involved when purchasing municipal bonds, but aside from that, there are still a few key factors that you should keep in mind before you go straight into the municipal bond market and pick the first option you see.

So, to wrap things up, let's walk through a few tips you can consider when shopping about:

Credit Quality

Most municipal bonds are issued by governmental entities themselves, but in the broader financial market, you'll more often than not see these kinds of loans be issued by private entities such as corporations and financial institutions instead, meaning it's absolutely imperative that you're aware of their specific credit scores before you take a loan out with them.

Now, this part can usually be a bit time-consuming if you're trying to handle it on your own since you're going to need to dig through a bunch of documents to gauge their financial health — meaning researching all their revenue sources and general management practices — but that's why tools like EMMA are so important here as they simplify a lot of the work.

This is a slightly different process than if you were trying to work out the credit quality of other types of loans like treasury bonds or consumer loans, as they're more about the financial strength of the issuing corporation or individual borrower (and things like the company's profitability or leverage).

As a general rule of thumb, though, just try to keep in mind that if a municipal bond is rated fairly highly, chances are they probably offer much lower yields (though they do still come with greater assurance of repayment!).

Obviously, this works conversely, too, as lower-rated bonds, while usually offering higher yields, tend to come with a way higher risk of default, so be careful if you're an inexperienced investor.

Impact of Interest Rates on Municipal Bonds

The ups and downs of interest rates can also have a pretty big effect on how well your municipal bond is going to perform because when interest rates are low, older bonds that might have higher coupon rates (which is basically the interest rate that the bond pays) can become a lot more valuable as they offer better returns than the newer bonds.

On the flip side, though, when interest rates are rising, you'd probably want to stay away from older bonds as it's the newly issued bonds that now have higher yields.

Understanding Municipal Bond Characteristics

We've discussed municipal bonds in a decent amount of detail throughout this article, but as is the case with all investment options, if you're still not 100% comfortable with how these kinds of bonds work, you stay away from the market entirely and not try to make stupid speculative investments like some people would on a random meme coin in the cryptocurrency space.

Things like when the bond actually matures, whether or not it can be called back by the issuer, and even how often the interest payments are made are all going to play a role in how much money you'll make from your investment — it's not just as simple as ‘apeing' into the first option you see with nice potential returns (though we'd never suggest our readers would do something so reckless!).

Related Guides:

FAQs

Can Investors Trade Municipal Bonds on Secondary Markets Similar to Stocks?

Can Municipal Bonds Serve As a Hedge Against Inflation?

What Role Do Financial Advisors Play in Municipal Bond Investing?

How Do Sinking Funds Influence Municipal Bond Investments?

Can Investors Sell Municipal Bonds Before Maturity?

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