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What are municipal bonds & how do they work?

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Municipal bonds can be an income-generating investment and a great way of diversifying your portfolio. So what exactly are they, and how do they work? Here's a brief overview of municipal bonds, the types to choose from, and their benefits and risks of investing.

What are municipal bonds?

Municipal bonds, also known as municipal securities or "munis," are bonds issued by entities like a state, county or municipality. These bonds also can be issued by other entities like senior housing developers, toll roads or infrastructure development groups. Issuers use munis for a variety of purposes, including raising money for general obligations or to fund projects, such as the construction of public roads, bridges, schools and other public works. Municipal bond interest is generally tax-free for investors at the federal level and sometimes at the state or local level.

For municipal bond interest to be tax-free at the state or local level, you must reside in the state where the bond is issued. Given the tax benefits, municipal bond interest is usually lower compared to bonds that are taxable, such as corporate bonds.

How do municipal bonds work?

A municipal bond is issued by a municipality, such as a city or local government. When an entity issues a bond, it's essentially taking out a loan, and the interest paid on the loan goes to investors who have purchased the bonds. The bond's interest is paid periodically, such as quarterly or semi-annually, at a fixed rate over a specified timeframe.

For example, let's say a local government wants to build a bridge and issues a 10-year municipal bond, paying 3% interest, to finance the construction. If you invest $5,000 in the bond, your investment represents a $5,000 loan to the government for 10 years. In return, the town will pay you $150 ($5,000 x 3%) annually in interest, possibly in quarterly or semi-annual installments. You also will receive back your $5,000 original investment, or principal, when the bond matures in 10 years.

Types of municipal bonds

There are two main types of municipal bonds: general obligation and revenue bonds.

  • General obligation bonds. These are issued by governmental entities and backed by the credit and taxing power of the issuing entity, rather than the revenue from a project. General obligation bonds are not tied to physical assets or the revenue they may generate.
  • Revenue bonds. These are a class of municipal bonds used to finance public projects like toll roads or airports, and then investors are repaid from the income generated from the project.

Benefits & risks of municipal bonds

Municipal bonds can provide you with some benefits, such as certain tax advantages. However, like any other type of investment security, municipal bonds also have their downsides, such as default risk.

Benefits of investing in municipal bonds

Some benefits of investing in municipal bonds include:

  • Tax-free income. Interest from municipal bonds is generally tax-free at the federal level. Residents whose primary residence is within the issuing municipality also may receive tax-free interest at the state or local level, if applicable.
  • Less risky than stocks. Municipal bonds are not risk-free but are often backed by the tax revenue of a government or the revenue of a project.
  • Can provide stable income. You can receive fixed income payments, which are typically every six months, for up to 30 years.

Risks of investing in municipal bonds

Some risks of investing in municipal bonds include:

  • Credit risk. This is the risk that the issuing government or municipality may experience financial challenges, making it difficult to make interest payments to bondholders. In some extreme cases, the bond issuer may fail to pay interest or principal, which is referred to as a "default." For many bonds, credit ratings are available to investors, letting you review credit risk.
  • Interest rate risk. When interest rates are rising, newer bonds being issued often pay higher rates to bondholders. This tends to make the price go down for current and previously issued bonds. So, if you want to sell your municipal bond in the open market, you may receive a lower price for the bond than you paid, causing a loss on the investment.
  • Inflation risk. Inflation, which is the general rise in the cost of goods and services, reduces purchasing power, which is a risk for investors receiving a fixed rate of interest.

Strategies for investing in municipal bonds

Investors can apply different strategies for investing in bonds, including a passive buy-and-hold approach, a ladder approach, or an active management approach. Some investors may benefit from a municipal bond fund, which can provide diversified exposure to the muni bond market.

  • Passive investing strategy. With this approach, you typically seek attractive yields and buy bonds that you plan to hold until maturity.
  • Bond ladder. With laddering, you buy and hold bonds at different maturities, which can take advantage of rising interest rates.
  • Active management approach. Investors may seek attractive yields for income but also may seek capital appreciation and sell the bond at a higher price than they purchased it.
  • Municipal bond funds. A municipal bond fund can be a good way to gain diversified exposure to multiple bonds inside one investment security.

Bottom line

Municipal bonds are versatile fixed-income securities that have multiple potential benefits, such as tax advantages and stable income. While municipal bonds may work well for some investors, they are not right for everyone. To learn more about current yields and how municipal bonds may work for you, contact a local Thrivent financial advisor.

Concepts presented are intended for educational purposes. This information should not be considered investment advice or a recommendation of any particular security, strategy or product.

While diversification can help reduce market risk, it does not eliminate it. Diversification does not assure a profit or protect against loss in a declining market.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.