3 Reasons I Like Municipal Bonds

It’s not easy being a bond investor these days. Bonds are generally thought of as conservative investments. But as we’ve seen this year, even conservative investments like bonds can lose money. Having said that, it’s not all doom and gloom for bondholders. Instead, I think there is potential opportunity in the municipal bond market.

Here are three reasons I like municipal bonds:

Reason #1 to like munis: Tax-free interest

Municipal bonds are issued by states and local municipalities to finance the construction of roads, schools and other infrastructure. The interest they earn is usually exempt from federal income taxes, and if issued in the town or state you reside may be exempt from state and local taxes as well. Meanwhile, the interest on private activity municipal bonds is taxable unless otherwise indicated.

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Tax-free income can be especially useful for retirees or highly compensated executives who have other income, such as pensions, annuities and deferred compensation plans, because it can help prevent “bracket creep” — when a taxpayer is bumped up into the next tax bracket. No one likes a creep, especially a bracket creep. That’s why I turn to municipal bonds for their tax-free interest.

Keep in mind that while muni interest is generally tax free, capital gains from selling a bond, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax.

Reason #2 to like munis: Be greedy when others are fearful

So far 2022 has not been kind to municipal bonds. As of April 12, 2022, the S&P Municipal Bond Index is down 6.78% for the year. Investors may have been spooked by events in Ukraine, inflation and the prospect for higher interest rates.

This is reason No. 2 why I like muni bonds. Research from investment firm Lord Abbett looking back over the past 12 years has shown there have been six distinct outflow cycles for muni bonds, and in the subsequent 12-month period the performance was overwhelmingly positive. Past performance is no guarantee of future results, but strong performance has typically followed large outflows in municipal bond funds.

Reason #3 to like munis: Low default risks

According to Moody’s Investor Service’s annual U.S. Municipal Bond Defaults and Recoveries (opens in new tab) snapshot, from 1970-2020 the default rate – when a bond fails to make interest or principal payments – remains “rare” overall for municipal bonds, at 0.08% over the course of the study. Even during the Covid pandemic up through 2020, according to investment firm VanEck, there were only two municipal bond defaults, and neither were virus related.

Muni bonds are by no means risk-free, but the low risk of default is comforting for my conservative clients.

Final thoughts

Municipal bonds have their advantages and disadvantages and are not suitable for all investors. However, given the reasons listed above, I think municipal bonds can help as part of a diversified portfolio.

There are many ways to purchase municipal bonds, including buying a bond fund, multiple different bond funds or individual bonds. There are short-, intermediate- and long-term as well as different types of municipal bonds, such as general obligation and revenue bonds. There are pros and cons to each approach. If you are unsure, I advise in speaking with a professional.

For more information on how to invest in municipal bonds or for a complimentary investment review of your portfolio, please email me at maloi@sfr1.com.