When it comes to diversifying your income, it’s important to consider more than just reducing investment risk. One way to diversify is by adding municipal bonds to your investment portfolio. These assets provide tax-advantaged income, making them an attractive option for many investors.
Municipal bonds, or “muni” bonds, are securities issued by local governments like cities, states, counties, or municipalities. Investing in muni bonds allows you to receive regular interest payments and get your initial investment back when the bond matures. The interest payments from municipal bonds are typically not subject to federal taxes, and in some cases, they may also be exempt from state and local taxes.
Understanding Municipal Bonds
There are different types of municipal bonds, including general obligation bonds and revenue bonds. General obligation bonds are backed by the government’s ability to tax residents, while revenue bonds are backed by specific projects or revenue sources, such as colleges or hospitals.
Pros and Cons of Municipal Bonds
| Pros | Cons |
|---|---|
| Tax-exempt from federal tax and possibly state and local tax | The bond price could fall |
| Low volatility | Not inflation-friendly |
| Minimal default risk | Still a chance of default |
Pros
- Tax-exempt: Muni bonds offer tax advantages, making them attractive for investors in high tax brackets.
- Low volatility: Municipal bonds are considered safe investments with low risk.
- Minimal default risk: Due to their backing by tax revenues or usage fees, the risk of default is low.
Cons
- Market prices could tank: If interest rates rise, the market prices of bonds may decrease.
- Not inflation-friendly: Municipal bonds may not keep up with inflation as well as stocks.
- Still a chance of default: While rare, municipal bonds can still default.
While municipal bonds offer tax advantages and low risk, they may not be suitable for all investors.
Considerations for Investing in Municipal Bonds
Individual Bonds vs. Funds
Investors must decide whether to buy individual bonds, mutual funds, or ETFs. Individual bonds offer potentially higher returns, while funds provide a diversified portfolio with lower risk.
Expenses are typically lower for ETFs compared to mutual funds, but actively managed mutual funds may outperform index funds.
Your Tax Bracket
Investors in higher tax brackets benefit the most from municipal bonds due to tax advantages. Calculating the tax equivalent yield can help compare the yield on muni bonds to other bonds.
Asset Location
Since municipal bonds offer tax advantages, it’s best to hold them in taxable accounts rather than tax-advantaged accounts like a 401(k) or IRA.
Conclusion
With their low default risk and tax exemptions, municipal bonds can be a valuable addition to an investment portfolio. However, it’s essential to remember that all investments carry some level of risk, and it’s crucial to conduct thorough research before making investment decisions.
— This article includes contributions from Bankrate’s Brian Baker.
Editorial Disclaimer: Investors should conduct their own research before making investment decisions, as past performance is not indicative of future results.