Municipal bonds, also known as “munis,” are debt securities issued by state and local governments to fund public projects and operations. Investing in munis can provide tax-advantaged income, as the interest payments are generally exempt from federal income taxes and sometimes state/local taxes as well. But are municipal bonds a good Investment in 2024? Here’s an in-depth look at the pros, cons, and smart investing strategies.
The Tax Benefits of Municipal Bonds
The key advantage of munis is their tax-exempt status on interest payments for investors. This can make the tax-equivalent yields on munis attractive compared to taxable bonds like corporates.
“Most munis interest income is exempt from federal income taxes. Many munis are also free from state and local taxes if you reside in the state/city where they were issued.”
This tax exemption allows muni investors to keep more of the interest income instead of paying taxes on it. The value of this tax benefit depends on your personal tax bracket:
- Higher income investors in top tax brackets can realize substantial savings
- Lower income investors may find less benefit if their tax rate is already low
Run the numbers using an online calculator to quantify potential tax savings benefits for your situation.
Lower Historical Default Rates Than Corporates
Another plus for munis is that they have demonstrated lower historical default rates compared to corporate bonds. According to Moody’s, the muni default rate averaged around 0.10% from 2000-2021 versus a corporate default rate of 3.51% over the same period.
So munis have generally been less risky than corporate bonds. However, defaults can and do occasionally happen, so some risk still exists.
Municipal Bonds Offer Diversification
Adding munis to an investment portfolio that contains mostly stocks/equities can provide increased diversification. While not completely immune to broader market swings, munis tend to be less volatile than stocks.
“A mix of stocks and municipal bonds can balance growth potential of equities with the lower-risk income provided by munis.”
And diversification helps smooth out a portfolio’s returns over market cycles.
Easy Access With Muni Bond Funds
Gaining exposure to municipal bonds is straightforward, even for smaller investors – mutual funds and ETFs provide diversified municipal holdings in a single ticker. Top national municipal bond ETFs include:
- iShares National Muni Bond ETF
- SPDR Nuveen Municipal Bond ETF (TFI)
- Vanguard Tax-Exempt Bond ETF (VTEB)
These muni ETFs provide broad exposure across many bonds/issuers instead of betting on a single issuer’s credit. Some advantages of municipal bond funds include:
- Diversification lowers default risk exposure
- Potentially better liquidity than trading individual bonds
- Still tax-exempt at fund level (investors realize tax benefits)
Considerations When Investing in Municipal Bonds
While municipal bonds offer some clear benefits, there are also important factors to weigh:
Higher Risk with Individual Muni Bonds
Buying an individual municipal bond ties your returns solely to that bond’s performance. A single municipal default could mean a total loss of the principal invested.
Mitigate this risk via diversification using municipal bond funds instead of individual bonds. Funds provide exposure to hundreds of municipal bonds.
Interest Rate Risk with Munis Still Exists
Municipal bonds carry interest rate risk just like all fixed income assets. When interest rates rise, prices on existing/outstanding bonds fall to match the yields available on newly issued bonds.
“This interest rate impact could result in muni bond investments declining in market price during periods of rising rates.”
One way to manage rate risk is to own muni bonds/funds with shorter-term durations instead of longer maturity bonds.
Inflation Can Eat Away at Munis’ Fixed Payments
While municipal bonds provide regular fixed interest payments, these nominal coupon payments lose purchasing power during inflationary periods.
Unlike stocks, which can potentially appreciate with inflation, munis provide no hedge against rising prices. Combine munis with assets that outpace inflation long-term.
Opportunity Cost vs. Taxable Bond Yields
The tax-exempt yields on municipal bonds are almost always lower than the prevailing taxable bond yields (e.g., corporate bonds). Investors accept the lower nominal yields in return for the tax savings benefits.
However, some investors may still find higher after-tax income with taxable bonds instead of munis after running the numbers. Use online yield comparison tools to assess this opportunity cost factor before investing.
READ ALSO: What is a Bond ETF and is it a Good Investment?
Municipal Bond Investment Strategies
If municipal bonds fit your fixed income allocation needs after weighing the pros/cons, here are some smart investment strategies to consider:
1. Long-Term Buy and Hold Approach
A prudent strategy is to own municipal bonds or funds over the long run as fixed income allocation core holdings. This buy-and-hold approach allows for compounding tax-exempt income over many years.
Regular muni fund contributions via dollar-cost averaging can build substantial holdings over time while smoothing out short-term price swings.
2. Laddering Maturities to Manage Interest Rate Risk
With individual bonds, investors can ladder maturities to mitigate interest rate risk. This staggered bond portfolio has bonds maturing each year to create something akin to an annual income annuity.
Laddering also provides principal to reinvest at updated rates, which prevents all holdings from maturing when rates are low.
3. Maintaining a Total Portfolio Perspective
Consider municipal bonds as part of an overall asset allocation plan rather than an isolated tactical play. Appropriate fixed income allocation helps balance equity risk exposures.
As with any asset class, don’t overexpose the portfolio to munis at the expense of diversification into stocks, real estate, etc. Periodically, rebalance back to target allocations.
Key Takeaways on Municipal Bonds as an Investment for 2024
- Taxable equivalent yields – Quantify how much extra taxable bond income would be needed to match the tax-free income from munis. This percentage gain via the tax exemption can be substantial for top tax bracket investors.
- Low historical default rates – Munis have demonstrated lower default rates than taxable bond alternatives, making them a relatively safe income investment.
- Interest rate risk still exists – While higher quality than corporate bonds, munis do carry interest rate risk. Expect some price volatility as rates rise and fall over economic cycles.
- Consider muni funds for diversification – Individual muni bonds pose higher default risk compared to diversified funds/ETFs that lower this hazard via broad exposure.
- Balance munis with growth assets – Fixed low-yield muni payments lose purchasing power to inflation over time. Combine with assets like stocks that can appreciate with rising prices.
Overall, municipal bonds remain an attractive fixed income allocation element for 2024 taxable investment portfolios – especially for high income investors optimizing tax exemptions.
The Bottom Line
Municipal bonds can play an integral role in balanced investment portfolio allocations, given their tax-advantaged income potential and historical stability. While not completely risk-free, investment grade munis provide low-volatility fixed income returns that are difficult to match with taxable bonds after factoring in the tax savings.
Maximize benefits and minimize risks via broad, diversified exposure using muni bond mutual funds and ETFs. Maintain an appropriate allocation in tune with your individual financial situation and risk tolerance – alongside equities, alternative assets, cash, and other key portfolio holdings necessary for prudent diversification.
FAQs About Municipal Bonds
What percentage of my portfolio should I allocate to municipal bonds?
Most financial planners recommend limiting fixed income (bonds) to between 20-50% of total portfolio assets, with the remainder in equities/stocks. An appropriate allocation depends on your risk tolerance, investment timeframe, and income needs.
Of your fixed income allocation, munis can occupy around 50-75% if you stand to benefit substantially from tax-exempt interest income. Diversify across both municipal funds and individual bonds.
What rating level is considered investment grade for municipal bonds?
Per the major credit rating agencies, municipal bonds with ratings of BBB or higher are considered investment grade – meaning higher quality with a lower risk of default. Approximately 90% of the overall municipal bond market currently ranks investment grade.
Bonds with BB and below ratings are deemed non-investment grade, or “high yield.” While they offer higher yields to compensate for higher perceived default risk, individual high yield munis introduce significant risk. Risk-tolerant investors may choose to get exposure via diversified high yield muni bond funds instead.
How do I know if a municipal bond is right for my situation?
Assess if you stand to benefit from municipal bonds’ tax-advantaged treatment. Calculate your current federal and state income tax brackets, then use an online municipal bond tax-equivalent yield calculator to compare taxable bonds.
This percentage gain in effective annual yield via the tax exemption can help determine if munis makes sense for you. Those in higher brackets tend to realize larger benefits from munis.
Additionally, consider your risk tolerance and desired portfolio stability. The lower historical default rates and higher quality of most investment grade munis make them suitable fixed income holdings for more conservative investors.
What are the best municipal bond funds to invest in?
Top-rated national municipal bond ETFs provide low-cost, diversified exposure to the broader municipal market:
- iShares National Muni Bond ETF
- SPDR Nuveen Municipal Bond ETF (TFI)
- Vanguard Tax-Exempt Bond ETF (VTEB)
These and other highly-rated muni ETFs hold hundreds of municipal bonds across states, sectors, and bond ratings – providing stability and lowering default risk compared to betting on individual muni bonds.
Evaluate historical returns, fees/expense ratios, liquidity profiles, and overall muni bond fund portfolio characteristics to select attractive muni bond funds matching your investment plan.
How liquid are municipal bonds if I need to sell?
Like all bonds, municipal bonds trade over-the-counter – so some liquidity challenges exist, especially for small retail investors. Thin trading volume for a specific muni issuer can result in high bid-ask spreads. Investing in muni mutual funds and ETFs sidesteps this liquidity issue via always available intraday trading/pricing on major stock exchanges.
The aggregate municipal bond market also maintains decent liquidity levels overall due to participation by large institutional investors and dealers. About 10-15% of outstanding municipal bonds trade monthly.
In another related article, Diversify Your Portfolio with Bond Investments
