What are Municipal Bonds? | Fidelity

Municipal bonds, often called “munis,” are debt securities issued by state and local governments, as well as their agencies, to fund public projects. When you purchase a municipal bond, you are essentially lending money to the issuer in exchange for regular interest payments and the return of your principal at a specified maturity date.

One of the most significant advantages of municipal bonds is their tax treatment. The interest income earned from most municipal bonds is exempt from federal income taxes and, in many cases, state and local taxes if you reside in the state of issuance. This tax-advantaged status can make them a compelling component of an investment portfolio, particularly for investors in higher tax brackets.

There are two primary types of municipal bonds: general obligation bonds and revenue bonds. General obligation bonds are backed by the full faith and credit of the issuing municipality, which has the power to tax residents to repay bondholders. Revenue bonds are secured by the specific revenues generated by the project they finance, such as tolls from a highway or fees from a water treatment facility.

Like all investments, municipal bonds carry certain risks that investors should understand. Credit risk refers to the possibility that the issuer may default on its payments. Interest rate risk is the risk that rising market interest rates will cause the value of existing bonds to fall. It is also important to consider liquidity, as some bonds may be harder to sell quickly without a price concession.

Before investing, it is crucial to assess your own financial goals, risk tolerance, and tax situation. Municipal bonds can offer a relatively stable source of tax-advantaged income, but they are not suitable for every investor. Consulting with a financial advisor can help you determine if they align with your overall investment strategy.

Investors should be aware of the key factors that influence a municipal bond’s risk and return profile. These include the credit rating of the issuer, the bond’s maturity date, the structure of its interest payments (callable or non-callable), and the overall health of the regional economy supporting the issuer.

• Credit Rating: Agencies like Moody’s and S&P assess the financial strength of bond issuers. Higher-rated bonds (e.g., AAA, AA) typically offer lower yields but carry less default risk.
• Maturity: Bonds with longer maturities generally offer higher interest rates to compensate investors for the increased risk of interest rate fluctuations over time.
• Call Provisions: Some bonds give the issuer the right to repay the bond before its maturity date, which can impact an investor’s expected income stream.
• Economic Base: The economic diversity and growth prospects of the municipality can affect its ability to generate tax revenue or project income to meet its obligations.

When evaluating a municipal bond, investors often overlook the impact of the secondary market on pricing. Unlike stocks that trade continuously on exchanges, many munis trade over-the-counter, and bid-ask spreads can be wide for smaller issues. This means that selling a bond before maturity may result in a price that differs significantly from its stated value, especially if the issue is thinly traded or the market is volatile. A practical approach is to hold bonds to maturity whenever possible or to focus on larger, more actively traded issues to minimize transaction costs.

For more detailed information on public finance and municipal debt, you can refer to resources from the U.S. Securities and Exchange Commission.