Understanding Muni Bond Risks and Investment Opportunities

Muni bonds are a type of investment that's often overlooked, but they can be a great way to earn a steady return while supporting local infrastructure projects.

Muni bonds are typically issued by municipalities to finance public projects such as schools, hospitals, and transportation systems.

They're considered a relatively low-risk investment because they're backed by the credit of the issuing municipality.

However, even low-risk investments can come with some level of risk, and it's essential to understand these risks before investing in muni bonds.

Credit risk is a significant concern for muni bonds, as the issuer may default on payments if they struggle financially.

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A muni bond is a type of debt security issued by local, county, and state governments to pay for capital expenditures like highways, bridges, and schools.

They act like loans, with bondholders becoming creditors who receive interest on their principal balance, which is repaid by the maturity date.

Municipal bonds are often exempt from most taxes, making them attractive to people in higher income tax brackets.

Investing in muni bonds can be as simple as buying a bond or investing in a mutual fund or exchange-traded fund (ETF) that specializes in muni bonds.

Muni funds can provide a well-diversified portfolio of bonds from municipalities with different credit ratings, reducing potential default risk.

Revenue bonds are issued by government entities and are secured by revenues from a specific government project, such as tolls or taxes.

Municipalities issue bonds when they need money for a project, and investors buying a muni bond fund that project over a set period.

The investor expects to receive interest or coupon payments and the initial principal back when the bond matures or the loan term ends.

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Muni bonds come in different forms, and understanding their characteristics is crucial for investors.

A general obligation bond is backed by a municipality's unconditional promise of repayment, which might come from a general fund or a dedicated local tax.

Revenue bonds, on the other hand, use the money generated by the project to fulfill debt obligations. This can include tolls from a bridge or tunnel, or ticket sales from a stadium.

Revenue bonds' yields can fluctuate depending on the amount of revenue collected from the sources.

Conduit bonds are issued by municipalities on behalf of private entities, such as universities or housing developers. In these cases, the conduit borrower is ultimately responsible for covering debt obligations.

Here's a breakdown of the main types of muni bonds:

Some muni bonds may not be tax-exempt, which means the income generated by these bonds is subject to federal taxes.

Municipal bonds are generally considered safe investments, but they do come with some risks. Default risk is low, but revenue bonds are more vulnerable to changes in consumer tastes or general economic downturns.

A bond's market price fluctuates with changes in interest rates, so when interest rates rise, bond prices decline, and when interest rates decline, bond prices rise. This means that investors may face losses if interest rates rise.

Municipal bonds are often illiquid, making it difficult for investors to sell them quickly if needed. Many bonds also carry call provisions, allowing the issuer to redeem the bond before the maturity date, which can result in investors losing income from interest payments.

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Default risk is low for municipal bonds compared with corporate bonds, but revenue bonds are more vulnerable to changes in consumer tastes or general economic downturns.

Revenue bonds are issued by government entities and are secured by revenues from a certain government project, but the bonds' yields can fluctuate depending on the amount of revenue collected from the sources.

The market price of a municipal bond fluctuates with changes in interest rates, causing bond prices to decline when interest rates rise and rise when interest rates decline.

A bond with a longer maturity is more susceptible to interest rate changes than a bond with a shorter maturity, causing even greater changes in the municipal bond investor's income.

Many municipal bonds carry call provisions, allowing the issuer to redeem the bond prior to the maturity date, which can result in investors losing income from interest payments and facing reinvesting in a bond with a lower return.

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Here are the three main types of muni bonds and their characteristics:

The income generated by a municipal bond may be taxable, and some forms of municipal bonds are not tax-exempt, which can affect their attractiveness to investors.

Municipal bonds are generally considered a safe investment, but default risk is still a possibility. Defaults are rare, but they can happen.

The Municipal Securities Rulemaking Board maintains a website with disclosure documents, pricing data, and other information valuable for muni bond investors. This can help investors evaluate the riskiness of each bond.

Credit rating companies such as Moody’s, S&P, and Fitch assign ratings to help investors evaluate the riskiness of each bond. These ratings can give investors an idea of the municipality's creditworthiness.

Defaults have happened in the past, such as in Detroit in 2014 and Puerto Rico in 2018. These events are a reminder that default risk is a real consideration for muni bond investors.

Researching the municipality and reviewing the credit rating for the bond you're interested in can help combat default risk. This can give you a better understanding of the potential risks involved.

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You can invest in municipal bonds through mutual funds or exchange-traded funds (ETFs), which can be a good option if you're not comfortable picking individual bonds.

This approach allows you to access a well-diversified portfolio of bonds from municipalities with different credit ratings, projects, and bond types, which can help lessen default risk.

By investing in a bond fund, you're also shifting responsibility to a fund manager who is experienced in municipal bonds and will monitor the municipalities and related risks for you.

A national muni fund can provide federal tax exemption, and some investment management companies even offer state-specific funds for investors who want to benefit from federal, state, and local tax exemption.

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ETFs can be a great way to invest in municipal bonds. They offer a low-cost and diversified portfolio of bonds from municipalities with different credit ratings.

One benefit of bond funds is that you are shifting responsibility to a fund manager, who is well-versed in municipal bonds and will monitor the municipalities and related risks for you. This can be especially helpful for those who feel uncomfortable picking municipal bonds on their own.

Some ETFs are specifically designed to track the performance of municipal bonds. These ETFs were selected based on their exposure to municipal bonds at a low cost. They are sorted by their 1-year total return, which ranges from 0.5% to 2.5%.

Here are some examples of municipal bond ETFs:

The expense ratios of these ETFs range from 0.05% to 0.65%, and the assets under management range from $930M to $34B.

One of the biggest draws to the municipal bond market is their tax-free status. Issued by states and local governments, these bonds offer a unique opportunity for investors to earn interest without paying federal or state taxes on the gains.

Municipal bonds are often considered a low-risk investment, especially when compared to stocks or other types of bonds. They're a popular choice for investors seeking a steady return with minimal volatility.

Investors can choose from a wide range of municipal bonds, each with its own unique characteristics and benefits. From general obligation bonds to revenue bonds, there's a muni bond to suit every investor's needs and goals.

Taxable municipal bonds, however, offer a high-yield alternative for investors who may not be eligible for tax-free gains. These bonds are issued by states and local governments, just like traditional municipal bonds, but the interest earned is subject to federal and state taxes.

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Municipal bonds have relatively low default risk compared to corporate bonds, but they're not entirely risk-free. Default risk is higher for revenue bonds, which are more vulnerable to changes in consumer tastes or economic downturns.

Market price fluctuations are a concern for municipal bond investors, as they're affected by changes in interest rates. When interest rates rise, bond prices decline, and when interest rates decline, bond prices rise.

The length of a bond's maturity also impacts its price sensitivity to interest rate changes. Longer maturity bonds are more susceptible to these changes, causing greater fluctuations in an investor's income.

Many municipal bonds are illiquid, making it difficult for investors to sell them quickly if needed. This means an investor may have to sell other securities instead.

Call provisions allow issuers to redeem bonds before maturity, typically when interest rates drop. This can be a risk for investors, as they'll lose income from interest payments and may face reinvesting in a bond with a lower return.