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Investing in municipal bonds

They’re less volatile than stocks but returns may not keep pace with inflation.

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Municipal bonds are a tax-advanced investment option for investors seeking steady, low-risk returns. But profits may be outstripped by annual inflation rates — especially for long-term investments.

What are municipal bonds?

A municipal bond is essentially a loan from an investor to a municipal government. They are tradable securities that can be bought or sold through a brokerage account. They’re considered a low-risk investment and are frequently referred to as “munis.”

Municipal bonds come in three forms: general obligation bonds, revenue bonds and conduit bonds.

How do they work?

Municipal governments issue bonds to borrow money for government projects and infrastructure. Investors purchase the bonds through a financial advisor, bank, online trading platform or from the municipality directly. Once the investor purchases the bond, the cost of the bond is forwarded to the issuing government agency.

Bond terms range from one to 10 years and investors receive regular interest payments — typically twice a year — until the bond’s maturity date when the principal amount is repaid in full.

Who issues them?

States, cities, counties and municipalities issue municipal bonds. Interest earned on these bonds is typically exempt from federal, state and local income taxes.

How much do they pay?

Annual rates for municipal bonds typically vary between 2% to 5%. The exact rate depends on several factors, including the length of the bond and the credit rating of the issuing municipality.

Municipal bonds tend to pay higher rates than federal bonds, as municipal bonds are slightly riskier than purchasing a bond offered by the federal government.

How to invest in municipal bonds

Brokerage accounts buy and sell bonds. Here’s a breakdown of the bond-buying process through an online brokerage:

  1. Compare platforms. Online brokerages come in many shapes and sizes. The platform you select should cater to your level of trading experience and offer access to the municipal bond market.
  2. Open an account. Most trading platforms offer a quick online application process. It’s likely you’ll fund your brokerage account with an external transfer from an existing bank account.
  3. Find a bond. Some stock screeners, like those offered by Finviz and Yahoo Finance, are equipped to analyze bonds. But you can also conduct research by visiting the Electronic Municipal Market Access website. This database allows you to select a state and compare available bonds by type, yield and term.
  4. Submit your order. Once you’ve found a bond you want to purchase, submit the order through your brokerage account.
  5. Monitor your investment. Log in to your account to track your investment.

Compare bond brokers

To purchase bonds from an online trading platform, you’ll need a brokerage account. Explore your options below.

Pros and cons of investing in municipal bonds

Every investment holds the opportunity for profit — and the potential for loss. Weigh the benefits against the risks before you invest.

Pros

  • Tax-free gains. Most municipal bonds offer returns free from federal, state and local taxation, offering a tax-exempt income stream and amplifying compound growth.
  • Low risk. As a fixed-income asset, municipal bonds are more reliable and less volatile than stocks.
  • Community support. Bond funds are typically used for government programs and projects, so when you invest, you have the opportunity to support your local community.

Cons

  • Low interest. While less volatile than stocks, bonds also tend to offer less enticing returns. And if interest rates rise, your bond may lose value.
  • Not inflation-proof. Bonds are typically long-term, low-yield investments. As a result, annual inflation rates may gnaw at your profits over time.

Are municipal bonds tax-free?

In many cases, yes. But there are some situations in which state and capital gains taxes may apply.

Municipal bonds are generally exempt from federal taxes — and in most cases, exempt from state taxes, too. But your state may charge taxes on bond interest income if the bond was issued by a state outside your own.

Bond investors need to be wary of capital gains taxes. If you sell a bond before its maturity date, you’ll be expected to pay federal and state capital gains taxes on any profit you pocket.

Types of municipal bonds

The U.S. Securities and Exchange Commission (SEC) defines three types of municipal bonds.

General obligation bonds

General obligation bonds are the most common type of municipal bond. They’re created to raise capital to ensure government expenses are repaid using tax revenue.

Revenue bonds

Revenue bonds cover the cost of revenue-generating projects, like toll roads or entertainment arenas. They’re repaid with the revenue generated by the project being funded, and if revenue trickles to a halt, the issuing government doesn’t have to repay the bond.

Conduit bonds

Conduit bonds help support private groups that serve the public, like nonprofit organizations and hospitals. In this instance, the municipality arranges the sale of the bond but isn’t held liable in the event of a default.

Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.

Bottom line

Bonds are a low-risk investment typically held by investors for years at a time. But these low-yield securities tend to have lower returns than stocks and annual inflation rates may dig into profits.

Before you invest, compare trading platforms for the brokerage account best suited to your needs.

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