When you see the latest hospital, school, highway, or airport alongside the road, you might not immediately imagine that it was likely partially financed with municipal bonds. In fact, two out of three infrastructure projects in the U.S. are financed with municipal bonds, according to a report by New York Life Investments.

Municipal bonds have a long history; the first was established in 1812 in New York City to raise money to build a canal. These days, they are still a tool used to help fund large, high profile projects. In 2018, for example, “the Denver International Airport issued $2.5B in bonds to finance capital improvements, the largest airport revenue bond in municipal bond history.” In 2016, “the New York State Thruway Authority issued $850 million in bonds to finance a portion of the new NY Bridge Project.” So, while municipal bonds might sound boring, they are helping communities to accomplish big things. 

Not only do municipal bonds (also called muni bonds) make many new infrastructure projects possible, they can generate passive, tax-free income for investors. 

While municipal bonds were initially hit hard by the COVID-19 pandemic, they have since recovered with robust Federal Reserve support. According to BlackRock, because COVID-19 is likely to drive higher government spending and record deficits which is in turn likely to drive higher taxes for investors, tax-free income vehicles like municipal bonds are likely to be more attractive than ever in the years to come. 

Here’s what investors should know. 

What Are Municipal Bonds?

Municipal bonds are financial vehicles for communities to build schools, fix highways, improve water systems, maintain bridges and tunnels, upgrade hospitals, and more. 

Municipal bonds are a means for investors to loan money that funds local infrastructure and public works programs. In short, when a municipality needs to raise money for an infrastructure project, they often issue bonds. These bonds fund a project over a designated period of time. During that scheduled period of time, investors are paid interest (typically semi-annually) until the bond matures, at which time they receive their initial principal back.

There are two types of municipal bonds, a general obligation (GO) bond and a revenue bond. A GO bond is usually backed by a municipality’s local government and carries an unconditional promise of repayment. GO bonds generally pay investors via a general fund or through a dedicated local tax. Revenue bonds fulfill debt obligations via raised money. For example, a bridge that collects a toll or a sporting facility that raises money via ticket sales. 

Municipal bonds are unique from many other bonds in that they are mostly tax-exempt at the federal level, and in many cases, at the state level as well. They have enjoyed their tax-free status since 1913.  According to the National Association of Counties (NACo), “the tax-exemption of municipal bond interest from federal income tax represents one of the best examples of the federal-state-local partnership.” The tax-exemption applies to earned interest. So, while corporate bonds might offer a higher earned interest rate, because corporate bonds are taxed, their take-home earnings might actually be less than their municipal counterparts. 

Municipal bonds also tend to outperform other vehicles like CDs, although municipal bonds have a slightly higher associated risk. Nonetheless, municipal bonds still have a relatively low default rate (lower than the corporate bond default). Between 1970 to 2011, there were only 71 municipal defaults, compared to 1,784 corporate defaults during the same time period, according to Moody’s analysis

One possible drawback is that municipal bonds tend to be less liquid than even their corporate counterparts, which investors should consider before investing.

Why Invest in Municipal Bonds?

Municipal bonds tend to help buffer portfolios as the stock market fluctuates.  Municipal bonds are unique in that they offer both tax-exempt income and high credit quality. They have particular appeal for income-oriented investors in higher tax brackets who want to reduce federal and state income tax bills. The municipal bond tax exemption makes them attractive enough that investors often choose them over their corporate counterparts. 

Regarded as a conservative investment, municipal bonds tend to fluctuate less than stocks. They typically pay a predictable amount twice per year. They also offer a low chance of default, especially considering that they are usually backed by taxes and fees generated by essential services.

Perhaps even more appealing, municipal bonds allow investors to invest their money locally. These bonds offer investors the opportunity to be a part of building their city’s newest football stadium or their community’s newest school facility, for example. 

Not only that, municipal bonds help to keep infrastructure decision-making power with state and local leaders in partnership with their residents, according to NACo. 

Investors should note that municipal bonds with a shorter duration often offer lower yields than longer duration bonds. Nonetheless, with either type, investors can anticipate getting their initial investment back and then some.  

Municipal bonds are a tangible way for investors to support infrastructure. Not only do they offer a range of benefits for investors, they benefit the communities where projects that they help to fund are built. For those reasons, they should be on every investor’s radar.

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The information and data are as of the January 28, 2021 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.

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