What are Municipal Bonds, and How Do They Work?
According to the Tax Policy Center, state and local governments had approximately $4.2 trillion in outstanding debt in the form of municipal bonds by the end of 2024. While insurance companies, banks and credit unions, and mutual funds invest in municipal bonds, individual investors are by far the largest shareholders of municipal bonds—holding nearly 66% of outstanding securities. Given that these are such a popular consumer investment, let’s dig into how they work and discuss their benefits and risks to help you learn if they’re right for you.
What is a municipal bond?
A municipal bond (also called a “muni”) is a type of debt security issued by a city, county, state, or other government entity to fund expensive and long-term capital projects such as the construction of roads and highways, water and sewage facilities, schools, airports, and bridges.
How municipal bonds work
To illustrate how municipal bonds work, let’s assume a state government wants to expand an airport at an estimated cost of $300 million with a 10-year completion timeframe. After deciding to issue bonds to help fund the project since budget allocations fell short, they seek taxpayer approval (typically via a ballot) for the additional proposed spending. Bonds are later issued with a maturity date of ten years (i.e., when the bond is due or investors recoup their original investment or principal) with a par (or denomination) value of $5,000 (typical for municipal bonds) set as the face value or value at maturity. With the coupon rate—the amount of annual interest paid to the investor—set at 3% in this example, someone who retains this bond would earn $150 in annual interest before receiving a principal investment of $5,000 ten years later.
Municipal bond types
Municipal bonds generally fall into two categories—general obligation bonds (GOs) and revenue bonds—and are based on the source of interest payments and principal repayments.
General obligation bonds (GOs)
States, cities, or counties issue general obligation bonds that carry less risk than other types as they’re backed by dedicated taxes on property or general funds (often referred to as “backed by the full faith and credit” of the issuer, meaning the government is authorized to tax residents for bondholder repayment purposes).
These bond types are further divided into two categories: unlimited tax and limited tax obligation bonds.
Unlimited tax obligation bonds
Unlimited tax bonds are backed by the power of the issuer in that various tax revenue sources can be used to repay the bonds.
Limited tax obligation bonds
Limited tax obligation bonds are narrower in taxing power since municipalities can pass a specific tax (e.g., a sales tax increase) to repay the debt.
Revenue bonds
Alternatively, revenue bonds are tied to income generated from a specific project or source such as money produced via tolls or hotel occupancy taxes. Given the gamble that these projects or taxes won’t produce enough money to pay investors back, revenue bonds carry more risk than general obligation bonds.
Water, sewer, and utilities revenue bonds are typically viewed as less risky within the revenue bond category as they’re essential services and therefore more likely to meet their debt obligations. Amongst many variables of course, education, hospital, and healthcare are often considered the riskiest investments within this category; according to Schwab, nearly 30% of all municipal bonds that default are in the hospital and retirement sector.
Within these two categories, a municipal bond can be structured in different ways—each with its own unique benefits, risks, and tax treatments. Once such example is a conduit bond, meaning when a municipality issues a bond on behalf of a private entity—typically a private nonprofit 501(c)(3) entity or private sector company such as a university or hospital—as a type of revenue bond. In this case, the private entity is responsible for repaying the debt and thus adds more risk as the issuing government agency isn’t the guarantor.
Municipal bond advantages
Several benefits of investing in a municipal bond include:
Tax advantages
The biggest benefit of investing in a municipal bond is the associated tax advantage. Generally speaking, the interest you earn on a municipal bond is exempt from federal taxes—with those who live in the state where the bond was issued sometimes also exempt from state taxes.
Low default risk
Municipal bonds also have a very low risk of default, especially compared to their corporate counterparts. According to Moody’s—a credit ratings business—only .08% of municipal bonds defaulted between 1970 and 2022 compared to 6.9% for corporate bonds during that same time period. What’s more, municipal bonds rated by a nationally recognized statistical rating organization (e.g., Moody’s, Fitch, or S&P Global) and (specifically) general obligation bonds have historically experienced even lower default rates.
Less volatility
Municipal bonds can also provide investors with a steady, predictable rate of return that’s less volatile than other investments (e.g., stocks) and typically offers a higher return than a certificate of deposit.
Diversification
Municipal bonds can also help with portfolio diversification, especially if you retain higher-risk investments.
Municipal bond disadvantages
Municipal bonds also come with several risks including:
Call risk
The bond issuer sometimes has an option to redeem the bond prior to the maturity date through a “call provision” carried by many municipal bonds. In this scenario, the bondholder receives all interest payments due up until that time as well as their invested principal. Generally speaking, a call provision is often executed when interest rates drop since the municipality can thus reissue bonds at a lower interest rate.
Interest rate risk
Municipal bonds also carry interest rate risk, especially when longer maturities are involved as this makes them more susceptible to rate fluctuations than bonds with short-term maturities. As interest rates rise, existing bond market prices decline. Consider our earlier example of a bond purchased for $5,000 with a 3% coupon rate that pays $150 in annual interest.
If interest rates rise to 5% and new bonds are issued, investors earn $250 in annual interest payments for their $5,000 investment; selling the bond for a new one means doing so at a discounted price with a similar 5% yield for the new owner. You can also sell your bond when rates fall, assuming a call provision isn’t enacted.
Risk of default
While these risks are much lower compared to corporate bonds, a default is also possible: meaning you won’t recoup your investment. This is especially true when the municipality is a conduit issuer or with respect to non-recourse bonds wherein revenue-backed bonds aren’t obligated to pay back bondholders if the intended revenue stream dries up.
Inflation risk
As municipal bonds tend to pay lower interest rates than other types of bonds, they can also summon inflation risks whereby the fixed rate of interest received falls below the cost of inflation—thus reducing your purchasing power.
How to invest in municipal bonds
You can buy municipal bonds in a variety of ways, such as by purchasing individual bonds or investing in munis via exchange-traded funds (ETFs) or mutual funds—a good option for those who don’t feel comfortable selecting bonds on their own.
In sum: are municipal bonds a good investment?
As with any investment, potential risks and rewards accompany municipal bond investments—meaning it’s often best to consider this option when looking to diversify your portfolio with a low-risk, tax-exempt opportunity.
Still have questions about municipal bonds, how they fit into your investment strategy, and/or how to begin investing in them? Schedule a FREE discovery call with one of our financial advisors to get them answered.
People also ask
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Fixed-rate municipal bonds are generally sold in denominations of $5,000. You can also purchase fractions of municipal bonds via many mutual funds and ETFs.
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Municipal bonds are generally categorized as either short-term (often a few years) or long-term (ten years or more).
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The dollar price of a municipal bond is the dollar amount an investor pays to buy it, often expressed as a percentage of the bond’s face value. If you purchase the bond at par, therefore, you’re doing so for 100% of its face value. You can also buy a bond at either a premium (above par) or discount (below par).
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Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.
