With Low Prices and High Yields, Municipal Bonds Are Alluring

Alan Appelbaum

October 31, 2022

Municipal Bonds

Municipal bonds are debt securities issued by state and local governments to finance public projects such as roads, bridges, and schools. They are typically exempt from federal, state, and local taxes, which makes them an attractive investment for people in high tax brackets. Municipal bonds typically have lower yields than other types of bonds, but they can still be a good way to diversify your portfolio and generate income.

Why Invest in Municipal Bonds?

Municipal bonds offer several advantages for investors. First, they are typically exempt from federal taxes. This can be a significant advantage for investors in high tax brackets. For example, if you are in the 35% tax bracket and invest in a bond with a 5% yield, your effective yield would be 3.25%. This is because you would only have to pay taxes on the interest you earn on the bond (5% x 35% = 1.75%).

Second, municipal usually have lower yields than other types of bonds. This may seem a disadvantage at first glance, but it makes them more stable than other types of bonds. This is because investors are willing to accept a lower yield in exchange for the stability of investing in government-issued debt.

Third, municipal bonds can be a good way to diversify your portfolio. This is because they tend to move independently of stocks and other investments. For example, if the stock market is going down, the bond market might increase (or vice versa). This makes municipal bonds a good way to hedge your bets and reduce overall risk.

Fourth, municipal bonds can provide a steady stream of income for investors. This is because they typically have maturities of 10 years or more. This means that you can invest in a bond today and know that you will receive regular interest payments for the next decade (or longer). And since the interest payments are exempt from taxes, this can be a great way to generate tax-free income.

What Are the Risks?

Of course, no investment is without risk. The two main risks of municipal bonds are credit risk and interest rate risk.

Credit risk is the risk that the bond issuer will not be able to make the interest payments or repay the principal when the bond matures. This is generally not a major concern with municipal bonds since most issuers have strong credit ratings. However, it is still something to keep in mind when investing in this type of security.

Interest rate risk is the risk that rising interest rates will make your bond less valuable. This is because new bonds are issued with higher yields when interest rates go up. As a result, existing bonds become less attractive to investors, and their prices go down. These are particularly sensitive to changes in interest rates because they have long maturities (10 years or more). Therefore, if you are investing in a municipal bond today with a 10-year maturity date, you need to be comfortable with the idea that interest rates could rise during that time period.

Municipal bonds offer several advantages for investors, including tax exemption, stability, diversification, and income generation potential. However, some risks are also associated with investing in municipal bonds, including credit risk and interest rate risk. Before investing in any type of security, it’s important to research and understand the risks and rewards involved.