How can you buy municipal bonds

Even bonds are not risk-free. The risk is that the issuer will default on its debts. Investors can judge the risk level of a bond they are considering by checking the bond's rating. All bonds sold in the U. Bond ratings are based on an analysis of the creditworthiness of their issuers.

The big selling point of municipal bonds is their federal tax-free status. That is, the interest payments are not taxed at the federal level. Some states do not tax municipal bonds, but others do. It is, not surprisingly, complicated.

Seven states have no income tax at all, so bond interest is a moot point. Other states don't tax in-state bonds but do tax out-of-state bonds in some circumstances. There are a number of reasons to look carefully at municipal bonds before taking the plunge, and to compare them against other choices for investing your money:. Use the tax-equivalent-yield formula to compare the real return on a muni bond with a corporate bond.

Translation: That's the yield that the muni must have in addition to its federal tax-free status to be equal to the yield of a corporate bond. Bonds used to fund local and state government projects like buildings and highways are afforded tax-exempt status at the federal level. Plus, people who purchase bonds issued by their states or localities may not be required to pay state or local taxes on the interest. That means some municipal issues have triple tax-free status. These tax advantages are offset by lower interest yields.

Municipal bonds typically have lower coupon rates than similarly rated corporate issues with comparable maturities. So, when considering munis, investors should compare the yields of taxable investment-grade and government bonds by using the tax-equivalent-yield formula.

Tax-equivalent yield TEY is the yield that a taxable bond must have to equal or exceed the tax-adjusted yield of a municipal bond.

In general, higher-income investors with theoretically higher tax bills are likely to benefit more from municipal bonds than individuals in other tax brackets. The risks of default by governments that issue muni bonds in the U.

However, bonds by definition have interest rate risk, which is important to investors who want to sell their bonds on the secondary market. When interest rates fall, a long-term investor may even face risk to their principal investment. A bondholder selling a year issue may receive less in principal than the bond initially cost. Over the past decade, annual inflation in the United States has ranged between Otherwise, it was 2.

This means that a year municipal bond that yields 2. Purchasing-power risk is the biggest potential drawback to investing money long-term in bonds. You'll get your money back in the end, but it may be worth less to you than it was. Investing solely in low-yielding municipal bonds is a safe approach but it could well mean giving up returns that exceed the rate of inflation and protect your purchasing power. A balance between municipal bonds and relatively riskier stocks can offset that risk.

Between and , 0. That's why muni bonds are considered a relatively safe investment. The acid test of muni bond resiliency came with the COVID pandemic as business activity ground to a halt and taxable receipts halted with it. Total defaults rose year-over-year to just 0. A bond that is issued with a callable option adds another risk to the investor.

It means that the issuer can cancel the issue, pay off the principal and stop the interest payments. The issuer wants that option, in case interest rates drop substantially, giving it the opportunity to issue a new bond at a lower interest rate. Most municipal bonds are callable. Their investors will get their money back, but they'll have to find a new way to invest that money.

A new investment in bonds will earn them less. The alternative minimum tax can be a tax trap for muni bond investors who have very high income from tax-shielded sources. As noted above, tax-free muni bonds are not always entirely tax-free. Bonds are particularly attractive to senior citizens seeking a steady stream of income for their retirement needs.

That makes Social Security income the most common pitfall for muni bond investors. Although the bonds are income-tax-free at the federal level, the income from muni bonds is counted towards the investor's adjusted gross income. A higher adjusted gross income can raise the portion of the taxpayer's Social Security income that is taxable. High-income individuals also can run into the alternative minimum tax, which is aimed squarely at taxpayers with substantial income from tax-shielded sources.

An investor can buy and sell bonds directly through an online brokerage account. Muni bonds are popular among investors. They can generate regular income and typically are exempt from federal taxes, as well as most state and local taxes, making them particularly attractive to those in higher tax brackets. Municipalities issue a bond when they need to raise money for a project.

An investor buying a muni bond is funding that particular project over a set period of time. They expect to receive interest or coupon payments usually semiannually and the initial principal back when the bond matures, or when the loan term ends. There are two main types of muni bonds, and they differ by where they get the money to pay investors.

A general obligation bond, or GO bond, is typically backed by a municipality's local government, with an unconditional promise of repayment. It might pay its investors from a general fund or through a dedicated local tax.

A revenue bond uses the money generated by the project to fulfill its debt obligations. Examples include a bridge or tunnel that collects tolls or a stadium using ticket sales to pay interest and principal back to investors. Sometimes a municipality issues a revenue bond on behalf of a private entity, such as a university, housing developers or health systems. These are called conduit bonds. In these cases, the conduit borrower has the ultimate responsibility of covering the debt obligations.

Check out the best online brokers. Limited time offer. Terms apply. As with any investment, it's important to weigh the pros and cons of municipal bonds before jumping in. Tax minimization: Many municipal bonds are exempt from federal taxes, and if the investor lives in the same state where the bond is issued, the muni will often be exempt from state and local taxes as well.

Here's how that calculation works:. An investor would need to find a taxable bond yielding 6. Being thoughtful about where they purchase tax-free muni bonds can save investors money.

For example, many investors in higher tax brackets strategically buy tax-exempt munis in their brokerage accounts, which are taxable.

They put their other less tax-advantaged fixed-income investments in retirement accounts like traditional IRAs and k s that are designed to defer taxes. Diversification: When it comes to investing, it makes sense to not put all your eggs in one basket and instead diversify your holdings. This helps minimize investment risk across your portfolio.

Conversely, issuers with a lower rating generally must offer higher interest rates to offset their associated risk. But remember that bond ratings can change. Just because an issuer starts out with a strong rating doesn't mean it can't get downgraded if its financial circumstances change. Muni bonds have a high rate of recovery even when they default, but your capital can be tied up longer than the term of the bond, and investors rarely recoup interest not paid.

So be sure to consider all the implications when considering which municipal bonds to buy. Municipal bonds differ from corporate bonds in the tax treatment of the interest they pay, and they also have lower default rates. This is why municipal bonds generally pay lower yields than similar corporate bonds. In short, the risk-reward profile for munis and corporate bonds is different.

If less risk is your priority, munis come out ahead; if better yields with higher risk suits you, corporate bonds get the nod. Discounted offers are only available to new members. Stock Advisor will renew at the then current list price. Average returns of all recommendations since inception. Cost basis and return based on previous market day close. Investing Best Accounts. Stock Market Basics. Stock Market. Industries to Invest In. Getting Started.

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