If you are seeking a steady income stream from your portfolio while trying to minimize the tax impact of that income, you may want to look into municipal bonds. Municipal bonds traditionally have had a relatively low default rate and may offer diversification benefits.1
Municipal bonds are debt securities that are issued by states, cities, counties, and other government entities. Issuers use the funds to fund day-to-day obligations and to pay for capital projects.
Municipal bonds come in two basic types: general obligation bonds and revenue bonds. General obligation bonds are backed by the issuer's taxing power. Revenue bond payments are funded by the revenues from a specific project or source.
The interest investors earn on most municipal bonds is exempt from federal income taxes.2 In addition, many states do not tax their residents on interest earned from municipal bonds issued in the state. The tax-exempt feature of municipals may mean that, after taking into account tax considerations, you can earn a better return on a municipal bond than you would from a higher yielding taxable bond.
The value of this tax benefit depends on your tax situation and is highest for investors in higher tax brackets or those who reside in high-tax jurisdictions.
You can potentially enjoy several other advantages apart from tax-exempt income when you invest in municipal bonds:
Like all investments, municipal bonds have their own set of risks. The financial health of an issuer and its ability to make timely payments of interest and principal is something you should investigate before buying. Various credit rating agencies, such as Moody's Investors Services, assess the credit rating of the governmental entities that issue municipal bonds. Generally, issuers with lower credit ratings tend to offer higher yields on their municipals to compensate for the added risk to your principal.
Municipals, like other bonds, are subject to interest rate risk. Rising interest rates cause bond prices to fall. In a period of rising interest rates, selling a municipal bond before it matures may mean having to accept a lower price than you paid for it. In addition, municipal bonds can be impacted by other market forces.
Despite credit, interest, and market force risks, municipal bonds may have a role to play in a carefully structured, diversified fixed-income portfolio. Your financial advisor can help determine whether your portfolio would benefit from holding municipals.
1Diversification does not ensure a profit or protect against loss in a declining market.
2The interest on certain "private activity" bonds must be included in income for federal alternative minimum tax purposes.