6 Myths About Municipal Bonds You Probably Believe
Most people, unless they come from the investment industry, don’t receive any formal education on how municipal bonds work. As a result, there’s a lot of misinformation out there surrounding these financial assets. At Neighborly, we want investors to make informed decisions and that means correcting these myths. Here are the top 6 myths that most people believe about muni bonds.
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Myth 1 — Investing in muni bonds is complicated
False. Because muni bonds don’t get as much media attention as the stock market, many investors are a less familiar with how they work. They often think that these investments are more complicated and challenging than they really are.
In reality, muni bonds are often more straightforward than many other financial investments, like stocks. You buy a bond and then receive fixed interest payments for a number of years. At the scheduled end of your bond, you should expect to get your entire initial investment back. While muni bond investing involves a little more than that, this sums up the overall idea.
Now, there are some risks with investing in muni bonds. For example, interest rates go up, the value of your bond portfolio will go down. Or, less common but it still does happen, if a city goes bankrupt, they will likely default on a majority of their bonds. However, muni bonds are typically safer investments than stocks.
Myth 2 — Muni bonds are always tax-free
False… although it is true that muni bonds are famous for their tax advantages they aren’t always tax-free. Some state and local governments issue bonds without any tax benefit. One reason they would do this is because they want to raise money for a cause that isn’t allowed to be tax-exempt, like raising money to build an airport.
If you own one of these bonds, your interest payments will be taxable or subject to the alternative minimum tax. When you buy a muni bond, look closely whether the interest payments are taxable or not taxable so you can avoid these bonds if you want to maximize your tax savings. However, these taxable muni bonds typically pay a higher interest rate so that helps offset the higher taxes.
Another time when you’d owe tax on a muni bond would be when you sell your bond to another investor for a profit, meaning you sell for more than you originally paid. In this case, your gains would be taxable as capital gains. If you are unsure about the tax treatment of your municipal bonds, consult your tax advisor.
Myth 3 — Muni bonds are only for extremely wealthy investors
False… although it is true that municipal bonds have a reputation of only being useful for wealthy investors. Since they’re in a higher tax bracket, they benefit the most from the tax benefits of muni bonds. This became a bit of a self-fulfilling prophecy because financial advisors tend to only market muni bonds to their wealthier clients.
At Neighborly, we’re trying to bridge this gap because muni bonds definitely aren’t just for the wealthy. Many investors appreciate the fixed returns on these assets and also enjoy putting money back in their community. While the tax benefits are a little more effective at higher tax brackets, even investors in lower brackets will see some tax savings.
For example, two investors buy a muni bond that is paying $1,000 a year in interest that is exempt from federal income taxes. One investor is in the 25% income tax bracket while the other is in the 35% tax bracket. The investor in the 25% tax bracket is exempt from paying $250 in federal taxes while the investor in the 35% tax bracket is exempt from paying $350 in federal taxes. While the higher earners do get more of a benefit, both investors avoid taxes by investing in a muni bond.
Also, some muni bonds waive the tax-free status altogether and pay a higher interest rate. These can be competitive for investors in lower tax brackets.
Myth 4 — Small investors can’t buy from governments
False. Governments sell muni bonds to individual investors directly. You can purchase munis when they are first issued during the retail order period. The majority of new municipal issues have a retail order period during which individual customers get first dibs on the bonds in question.
Neighborly will soon be offering investors the opportunity to purchase municipal bonds directly from the government, thereby eliminating the often-expensive middleman. You can sign up now to join the waitlist.
Myth 5 — General obligation bonds are always a safer investment than revenue bonds
False. First, a brief explanation about the two types of muni bonds:
General obligation bonds (GO bonds) — these bonds backed by the taxing power of the municipal government. The government agrees to pay bondholders out of all its tax income.
Revenue bonds — These bonds are backed by money earned from a specific project, like toll highways or a new hospital. Bondholders can only be paid out of the revenue from the project that the bonds are funding. If the project doesn’t raise enough money, the government won’t make up the payments from its other revenues.
Because of this setup, GO bonds are typically viewed as safer because they have more sources of income to make the payments. However, this isn’t always the case. Since governments can go bankrupt and default on their bonds, it’s possible to lose money on a GO bond. When making a decision, consider looking at the financial statements and the rating behind each bond if available. A revenue bond with a AAA rating is likely safer than a GO bond with a BBB rating.
Myth 6 — Muni bond funds are always a better deal than individual muni bonds
False… it’s important to understand the fees associated with funds. While a fund may claim a low fee, such as .25%, that isn’t the entire story. Like individual buyers, the fund also pays fees on the bonds it buys. So bond funds add another layer of fees but only talk about their own management fee.
A muni bond fund combines your money with the money of many other investors to build a portfolio of different municipal bonds. This can be an easy way to invest in muni bonds but it’s not always the best way.
Muni bond funds typically charge an annual fee for running the fund. The average muni bond fund charges an annual management fee of 0.96% and some funds charge significantly more. This cuts into your return. Also, the fund puts together the portfolio so you don’t control what muni bonds you own. Finally, when interest rates go up, the value of a muni bond fund goes down whereas if you hold individual bonds until maturity, you get your full investment back.
On the other hand, muni bond funds are convenient because a professional investor is managing the portfolio for you. A bond fund also gives you the chance to immediately buy into a large portfolio of different bonds improving diversification. You don’t need to spend the time building the portfolio yourself.
Finally, bond funds make it easier to reinvest your interest payments. If you receive a $500 interest payment, that won’t be enough to buy a brand new bond. That money will then be sitting in your bank account not earning any interest until you have enough saved up to buy a new bond. With a bond fund, you could immediately reinvest that money to start earning interest.
Reasons to consider individual bonds
- You want complete control over your portfolio
- You want to avoid the extra fees associated with bond funds
- You’re willing to do the research to find and buy individual bonds
Reasons to consider muni bond funds
- You want an investment that’s managed for you
- You want to immediately buy into a large, diversified portfolio of bonds
- You want your interest payments to automatically go back into more muni bonds
Don’t let these muni bond myths throw you off track. By keeping this information in mind, you can make better decisions for your portfolio and your investment future.
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