With most savings account interest rates barely grazing the 1 percent mark and short-term CDs not faring much better, those hesitant to embrace the volatility of the stock market have, in recent years, been forced to either step outside their comfort zones or resign themselves to slow financial growth. If you’re tired of measly interest rates but aren’t ready to abandon your risk-averse tendencies, there’s another option to consider: municipal bonds.
Also known as muni bonds, municipal bonds are debt obligations issued by government entities such as states, cities and counties. They’re often used to fund public projects like roadway construction and utility infrastructure. Similar to corporate bonds, municipal bonds essentially promise to pay the lender — in this case, you — a specified amount of interest over a period of time, and return the principal investment once the bond matures, or comes due. While municipal bonds are a good choice for some investors, they aren’t for everybody. Let’s review.
• Municipal bonds are generally tax-free, meaning the interest you earn on them is exempt from federal income taxes and, in some cases, state taxes as well. Interest from a CD or savings account, on the other hand, is not only subject to taxes, but is taxed as ordinary income, which means it’s treated the same way as your regular paycheck.
• Municipal bonds are a relatively safe investment. Compared to corporate bonds, their default rate (the failure of the issuer to make scheduled payments) is extremely low. Because of this, muni bonds offer a reasonably predictable income stream from interest, with most long-term bonds making semiannual payments.
• Compared to other investment options, municipal bonds generally have a lower interest rate. Over the past 10 years, municipal bonds have yielded just over 4 percent on average, whereas corporate bonds have averaged between 5 and 7 percent.
• While municipal bonds are considered low-risk, they aren’t risk-free. Though defaults are rare, they can happen.
• Municipal bond values are subject to market fluctuation. Let’s say you invest $10,000 in a 10-year muni bond but find that you need to sell it two years after adding it to your portfolio. If the market value at the time is only $9,000, you’ll lose $1,000 of your principal in exchange for immediate cash. You should only count on a full return of your principal if you hold the bond until its maturity date.
Under the right circumstances, municipal bonds are a wise investment. Consider adding muni bonds to your portfolio if you’re in a high tax bracket or expect to have a lot of taxable income in a given year, as their interest income won’t increase your tax burden. And if you’re new to investing and want to limit your exposure to risk, municipal bonds are a reasonably safe option. Finally, if you have an emergency fund and aren’t anticipating any imminent purchases requiring a large sum of cash (such as a house), municipal bonds are a great way to diversify your long-term savings plan.