What is a municipal bond? How to earn tax-free income by investing in projects that impact your community

• Municipal bonds are debt securities issued by local governments to fund public projects like schools, hospitals, or highways.
• Investors buy municipal bonds because interest earned is exempt from federal income taxes, and in some cases, from state and local taxes.
• Because they are tax-efficient investment, municipal bonds are best for taxable accounts as opposed to tax-advantaged retirement accounts.

Imagine a relatively safe, long-term investment that generates income, allows you to save on taxes, and funds public projects crucial a community.

That's essentially what happens when you invest in municipal bonds, which allow you to invest in the infrastructure of state and local communities while adding diversity and tax efficiency to your portfolio.

Here's what you need to know about municipal bonds, from why they're popular among tax-smart investors to how they can benefit your portfolio.

What are municipal bonds?

A municipal bond, or "muni" for short, is a type of bond issued by a state or municipality to help fund necessary public works projects.

Munis are popular with investors because of their tax advantages. Interest earned on municipal bonds is usually exempt from federal income tax. If you purchase a muni in the state you live, it could also be exempt from state and local taxes. Earning tax-free income is especially attractive to investors in higher tax brackets.

Quick tip: Muni bonds exempt from federal, state, and local taxes are known as "triple tax-exempt."

Investors also like the inherent safety of municipal bonds. In most cases, because you are investing in a bond used to help finance infrastructure backed by a local government, you can usually count on getting your principal back at maturity.

How do municipal bonds work?

At its most basic level, a bond is a loan made by an investor to a borrower. Whereas treasury bonds are issued by the US government and corporate bonds are issued by companies, municipal bonds are issued by local and state governments.

State and local governments issue municipal bonds to help pay for a wide range of projects including roads, schools and hospitals. Investors who purchase these bonds lend money to the municipality in return for regular interest payments (usually semiannual) for a set amount of time.

Principal is repaid when the bond matures, or when the loan ends. Munis have a wide maturity range of one to 30 years.

Types of municipal bonds

There are two types of municipal bonds, and they differ based on how they pay back investors:

• General obligation bonds: These bonds are secured with tax revenue and backed by the issuing municipality's taxing power. The population, demographics, economic diversity and budget outlook of the government issuing the bonds all play a role in the bonds' strength and creditworthiness.
  
  General obligation munis are often considered safe investments because, in most cases, the population is committed to the project and the municipality can use its power of taxation to repay the debt.
• Revenue bonds: These bonds are repaid by revenue generated by the project. For instance, revenue raised from tolls from a highway project can be used to pay back bondholders. Or a new hospital may use cash from operations to pay interest and repay principal.
  
  Revenue bonds are thought to be riskier than general obligation bonds because of the limit on funds used to repay bondholders. Unlike general obligation bonds, revenue bonds cannot rely on taxes to pay back the bonds.

It's important to pay special attention to the type of account you use to purchase these bonds. In a traditional IRA or 401(k) retirement account, earnings already grow tax-free. Most investors find holding munis in taxable brokerage accounts help make the most of munis' tax-free status.

In rare cases, municipal bond interest may not be exempt from federal taxes if they are used to fund an activity not qualified for tax-exempt status under IRS rules, like paying pension fund liability. It is usually obvious to you, your broker or your advisor when a muni is not exempt from federal taxes.

Investors who buy and sell municipal bonds may be liable for capital gains tax on profits from those sales or for bonds purchased at a discount price. In addition, if you are subject to the alternative minimum tax, you may be required to pay some taxes on municipal bond interest.

Are municipal bonds safe investments?

Municipal bonds are considered relatively safe investments because they have lower default rates and higher credit ratings than corporate bonds. Plus, many munis are backed by insurance that guarantees payment in the event of a default.

That's not to say munis are immune from default. For example, during the Puerto Rican debt crisis and the Detroit city bankruptcy, there were several muni bonds that could no longer make payments.

If municipal bonds pique your interest, it's important to understand credit ratings. There are three major credit ratings agencies - Standard & Poor's (S&P), Moody's and Fitch - all of which rate the issuers of municipal bonds based on their ability to meet their financial obligations. This makes it easier for investors to evaluate risk.

Quick tip: To research muni bonds in your area, visit the Electronic Municipal Market Access (EMMA) website, where you can find key information like bond type, yield, maturity, credit quality, and risk factors.

Although many munis receive the highest ratings from the agencies, such as AA+ or Aa1, it's important to remember that ratings can be downgraded during the life of the bond if a municipality's financial situation changes.

Like all bonds, munis also carry interest rate risk. When interest rates fall, prices for existing bonds paying higher rates will rise. In turn, when interest rates rise, prices on existing bonds paying lower rates will decline. If you hold muni bonds to maturity, price risk is not a factor. You only experience the ups and downs if you are buying and selling muni bonds.

How much will I earn from municipal bonds?

In return for safety and the tax advantages, investment-grade municipal bonds often yield less than their taxable counterparts, such as corporate and government-issued bonds.

High-yield munis, or munis that come from less-creditworthy issuers, can have significantly higher yields than investment-grade munis ,but they come with more investment risk. Investors in high-tax brackets may find that the tax advantages of investing munis help bridge the gap between muni and taxable bond rates.

Quick tip: The tax-equivalent yield (TEY) helps investors compare taxable bonds to tax-free muni bonds. To calculate the TEY, take the tax-free municipal bond yield divided by [1-marginal tax rate].

For example, if you're in the 35% tax bracket and looking to buy a tax-free muni bond yielding 4%, the TEY is 4 divided by [1-0.35], which is equal to 6.15%. A taxable bond yielding 6.15% would be the equivalent of the yield of this muni bond.

How to buy municipal bonds

In most cases, you buy and sell municipal bonds through a broker. There are three main ways you can invest in munis:

• Individual bonds bought through a broker require you to do your own research and decide whether to buy new issues or bonds sold through the secondary market, where you can buy munis already issued to other investors. You'll also need to investigate credit risk carefully, since your own portfolio of muni bonds will likely not be as diversified as a mutual fund or ETF.
• Municipal bond mutual funds invest in a wide-range of muni bonds, offering investors the diversity they can't get on their own, while still providing the federal tax advantages on income and in some cases some limited state and local tax breaks. If the upside is instant diversification and professional management, the downside is recurring management fees. You'll also be subject to capital gains tax when you sell your shares.
• Mutual bond ETFs are a good way to invest in a diverse array of municipal bonds. Like mutual funds, income is exempt from federal taxes and some interest earned may also be tax exempt at the state and local level, depending on where you live.
  
  ETFs trade like stocks on the market with prices fluctuating throughout the day, so you may experience more volatility with an ETF than a mutual fund. Like mutual funds, you'll be subject to capital gains tax when you sell your shares.

Whatever investment you choose, be sure to pay attention to the account you are using to purchase muni bonds. You likely don't want them as part of your tax-deferred retirement accounts such as traditional IRAs or 401(k)s where you won't get the full force of the tax exemptions. Better to put them in a taxable brokerage account.

The financial takeaway

Municipal bonds can offer a relatively safe, tax-advantaged way to diversify your fixed-income portfolio. While yields may not be as high as taxable bonds, the tax exemptions on interest earned can help even the playing field. Investors in high-tax brackets looking to diversify their taxable investment accounts may be best suited to municipal bond investing.