How to Buy Municipal Bonds

Municipal bonds are debt securities that help fund the daily operations or long-term projects of a state, county, city or other government organization. Government entities issue municipal bonds, offering interest payments typically on a semi-annual basis. How to purchase municipal bonds depends on whether they are bought during a new issue or on the secondary market. Investors can acquire them through brokerage firms, banks or directly from the issuing municipality. Mutual funds and ETFs also provide access to diversified pools of municipal bonds.

A financial advisor can determine if municipal bonds fit your portfolio strategy. 

How to Buy Municipal Bonds

There are several ways to invest in municipal bonds, depending on your financial goals, budget, and preference for professional guidance. Below are the primary methods to consider.

Buying Municipal Bonds Through a Brokerage

One of the most direct ways to purchase municipal bonds is through a brokerage account. Many brokerage firms offer access to both new-issue bonds and those traded on the secondary market. Investors can compare bond prices, credit ratings, yields and tax implications before making a purchase. Some brokers also provide research tools to help evaluate different municipal bonds based on risk and return expectations.

Investing in Municipal Bond ETFs and Mutual Funds

For those looking to invest with a smaller budget or seeking diversification, municipal bond exchange-traded funds (ETFs) and mutual funds offer an alternative. These funds pool multiple municipal bonds, reducing individual bond risk and eliminating the need for in-depth research. They also provide liquidity, allowing investors to buy and sell shares like stocks. Additionally, they can be a cost-effective way to access a diversified municipal bond portfolio without the transaction fees typically associated with individual bond purchases.

Working With a Financial Advisor

Investors who prefer professional guidance may consult a financial advisor to determine whether municipal bonds align with their investment strategy. Many advisors recommend municipal bonds for clients seeking stable, tax-advantaged income, particularly those in higher tax brackets. A financial advisor can help construct a balanced portfolio that integrates municipal bonds with other assets based on risk tolerance and investment horizon.

Using a Robo-Advisor for Municipal Bond Exposure

For an automated approach, robo-advisors offer municipal bond exposure through pre-allocated investment portfolios. These platforms use algorithms to match investors with portfolios based on their risk preferences, often at lower fees than traditional advisors. While robo-advisors may not provide personalized municipal bond selection, they offer a hands-off, cost-effective way to gain diversified exposure to municipal bonds within a broader investment strategy.

Types of Municipal Bonds

Government entities, including state, county, and city governments, issue municipal bonds as debt securities. These funds help finance public infrastructure projects such as roads, highways, schools, and other community developments. In essence, municipal bonds represent a loan from you, the investor, to these governments, with the expectation of regular interest payments. These bonds have fixed maturity dates, often set years in the future.

Tax benefits are a major draw of municipal bonds. For example, the interest income earned over the life of a municipal bond is exempt from federal taxes. In some cases, you may even find that you can skip out on state and local taxes, as well. This, however, is ordinarily reserved for residents who invest in their own state or local government’s munis.

1. General Obligation Bonds

General obligation (GO) bonds are backed by the taxing power and credit of the issuing government entity. In layman’s terms, this refers to the method through which investors will be paid back for their investment, which for GO bonds is either through revenue generated from completed projects or taxation. These investments are considered low-risk since they do not require collateral and are backed by the government’s ability to levy taxes.

2. Revenue Bonds

Revenue bonds repay investors using revenue generated from the project they finance. The best way to envision this is the building of a toll plaza on a highway. If a government uses the assets invested in its revenue bonds to fund the tolls, the money that drivers pay will go to repaying investors. They are mostly sold in $5,000 increments, ¹ and because they lack taxation as a repayment method, they are riskier than GO bonds. In return, they are paired with stronger interest rates. Revenue bonds are usually long-term investments, as their maturation dates are often a couple decades in the future.

3. Municipal Notes

Unlike GO and revenue bonds, municipal notes mature within a few months to three years. Governments also offer these to fund public projects that require more capital. They come in three forms: tax anticipation notes (TANs), revenue anticipation notes (RANs) and bond anticipation notes (BANs). Each of these choices are secured by taxes, non-tax revenue, and future long-term bonds, respectively.

Benefits and Risks of Municipal Bonds

Like most other bonds, municipal bonds are, for the most part, very reliable investments. Backed by county, state or local governments, municipal bonds typically provide reliable semi-annual returns. These investments can help balance a long-term portfolio, as they often take decades to mature.

Despite their low-risk nature, municipal bonds are not immune to risks. The three primary risks to consider are:

• Interest Rate Risk: As long as interest rates stay low, the market value of a municipal bond will remain high. However, if interest rates begin to increase, your muni investment could lose overall market value.
• Call Risk: Some municipal bonds are callable, which means that government issuers will have the opportunity to pay them off early if interest rates go down. Should this happen, you could lose out on returns.
• Credit Risk: Credit ratings indicate the reliability of municipal bonds, helping investors assess their default risk. But even government entities can default, in which case your returns may end up in serious jeopardy.

Comparing Municipal Bonds to Other Investments

Equities are among the riskiest investments, as their value fluctuates based on company performance. This quality, however, affords them much higher return possibilities than their peers, including municipal bonds. The best choice for your portfolio depends on your risk tolerance and long-term financial goals. If retirement is far off, taking on more equities may be a viable option. But if your golden years are on the horizon, municipal bonds offer reliable returns.

ETFs are one of the most popular investment choices. Diversification is key to the health of any portfolio, so the fact that ETFs are inherently diversified makes them a favorite. ETFs come in many versions, such as market-index ETFs, equity ETFs, alternative investment ETFs and even municipal bond ETFs. These funds provide a perfect balance for investors who want the benefits of munis but are unable to diversify due to a lack of trading confidence or funds.

How to Evaluate a Municipal Bond Before Buying It

Deciding to invest in municipal bonds is the first step. Evaluating a specific bond before purchasing it is where the actual work happens. These are the factors that matter most when assessing whether a particular municipal bond belongs in your portfolio.

Credit Ratings

Credit ratings from Moody’s, Standard and Poor’s, and Fitch assess the financial health of the issuing government entity and its ability to make interest payments and repay principal at maturity. Bonds rated in the top four tiers, generally referred to as investment grade, carry lower default risk. Bonds rated below that threshold offer higher yields to compensate for the increased probability of missed payments or default.

For most individual investors, staying within investment-grade municipal bonds is appropriate. Within that range, there is still meaningful variation. A AAA-rated general obligation bond backed by a state’s taxing authority carries different risk than a BBB-rated revenue bond dependent on the income generated by a specific project. Reviewing the rating and the rationale behind it, not just the letter grade, gives a more complete picture of the risk you are taking on.

Yield to Maturity

The coupon rate printed on a municipal bond tells you the annual interest payment as a percentage of the bond’s face value. What it does not tell you is what you will actually earn if you buy the bond on the secondary market at a price above or below face value.

Yield to maturity accounts for the purchase price, the coupon payments and the return of principal at maturity to produce a single annualized return figure. A bond trading at a premium to face value will have a yield to maturity below its coupon rate. A bond trading at a discount will have a yield to maturity above it. Comparing bonds by yield to maturity rather than coupon rate gives you an apples-to-apples comparison of what each bond actually pays.

Tax-Equivalent Yield

Municipal bond interest is generally exempt from federal income tax and, for residents who buy bonds issued in their own state, often exempt from state income tax as well. That tax advantage makes the comparison between a municipal bond and a taxable bond more complex than simply comparing yields.

The tax-equivalent yield converts a municipal bond’s yield into the equivalent pretax yield a taxable bond would need to offer to produce the same after-tax return. The formula is straightforward: divide the municipal bond’s yield by one minus your marginal tax rate. For an investor in the 37% federal bracket holding a municipal bond yielding 3.5%, the tax-equivalent yield is approximately 5.56% (3.5% divided by 0.63). A taxable bond would need to yield more than 5.56% to outperform that municipal bond on an after-tax basis for that investor. The higher your tax bracket, the more valuable the municipal bond’s tax exemption becomes.

Call Provisions

Many municipal bonds include a call provision that allows the issuing government to redeem the bond before its stated maturity date, typically when interest rates have fallen and the issuer can refinance at a lower cost. For the investor, a call means the bond is repaid early and the principal must be reinvested at whatever rates are available at that time, which are likely lower than when the bond was originally purchased.

Before buying a callable municipal bond, review the call date, the call price and whether the bond is currently trading above that price. A bond trading well above its call price in a declining rate environment carries meaningful reinvestment risk. Comparing the yield to call, which calculates the return assuming the bond is called at the earliest possible date, alongside the yield to maturity gives you a more complete picture of the range of outcomes.

Duration and Interest Rate Sensitivity

Duration measures how sensitive a bond’s price is to changes in interest rates. A bond with a longer duration will experience a larger price decline when interest rates rise than a bond with a shorter duration. For investors who plan to hold bonds to maturity, price fluctuations along the way are less relevant. For investors who may need to sell before maturity, duration is a meaningful risk factor.

As a general rule, longer-maturity municipal bonds carry higher duration and are more sensitive to rate changes. In an environment where rates are rising, shorter-duration bonds preserve value better than long-duration ones. Matching the duration of your municipal bond holdings to your actual investment horizon reduces the likelihood that you will need to sell at an unfavorable price before the bond reaches maturity.

Bottom Line

Municipal bonds can be a valuable investment for investors with varying risk preferences. For risk-averse investors, fixed-income securities like municipal bonds provide stability. Even aggressive investors can benefit from municipal bonds to balance stock holdings. While individual municipal bonds can be costly, municipal bond ETFs provide a more accessible alternative.

Retirement Planning Tips

• Many Americans’ lives are overwhelmingly busy. This pushes some important matters, like retirement planning, to the back burner. Financial advisors are often able to help clients plan their retirement through managed investment accounts and can even manage your investments for you. If you don’t have a financial advisor, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Planning your retirement savings becomes much simpler when you have a general idea of what your retirement income will look like. The SmartAsset retirement calculator will shed light on exactly how much retirement income your current investments can afford you.

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