Municipal bonds are often viewed as relatively conservative investments, especially because they are issued by state and local governments. But as Detroit’s 2014 bankruptcy reminded investors, municipal bonds still carry risk. Not every bond has the same level of security, and understanding the differences can help investors make more informed decisions.
The Two Main Types of Municipal Bonds
At a basic level, municipal bonds generally fall into two categories:
General Obligation Bonds
General obligation bonds are backed by the issuing municipality’s ability to raise revenue, often through taxes. In simple terms, the issuer is promising to use its taxing authority to help make timely interest and principal payments to investors.
Revenue Bonds
Revenue bonds are backed by the income generated from a specific project or service. For example, a revenue bond may be tied to toll roads, airports, utilities, hospitals, or other public projects. Payments to investors depend on whether that project or service produces enough revenue.
Because revenue bonds rely on project-specific income, they may carry more risk than general obligation bonds.
Common Risks of Municipal Bonds
Municipal bonds can play an important role in an investment portfolio, but they are not risk-free. Both general obligation and revenue bonds may be affected by:
Market risk: Bond prices can rise or fall as interest rates and market conditions change.
Credit risk: The issuer may experience financial difficulty and become unable to make payments.
Liquidity risk: Some municipal bonds may be difficult to sell quickly or may need to be sold at a lower price.
Inflation risk: Inflation can reduce the purchasing power of the interest and principal received.
Call risk: Some bonds may be redeemed by the issuer before maturity, which can affect the investor’s expected income.
Understanding these risks is especially important for investors who rely on municipal bonds for income, tax planning, or long-term stability.
How Investors Can Manage Municipal Bond Risk
One way to help manage risk is to focus on investment-grade municipal bonds. Investment-grade ratings generally indicate that a bond issuer is considered more financially stable, though ratings are not a guarantee.
Bonds tied to essential services may also be viewed as more stable. For example, water, sewer, and utility-related bonds often support services that remain necessary regardless of broader economic conditions.
Diversification is another important consideration. Because the financial health of any single city, county, or project cannot be guaranteed, spreading investments across multiple issuers, regions, and bond types may help reduce exposure to one specific risk.
For many individual investors, municipal bond mutual funds or professionally managed portfolios may offer advantages. Municipal bonds are often sold in $5,000 increments, and smaller investors may not always receive the same pricing, research access, or diversification opportunities as larger institutional buyers. A professionally managed approach can help provide broader diversification, credit research, and ongoing monitoring.
The Bottom Line
Municipal bonds can be a useful tool for income, diversification, and tax-aware investing. However, not all municipal bonds are created equal. The type of bond, the strength of the issuer, the purpose of the bond, and the overall structure all matter.
Before investing, it is important to understand what backs the bond, how payments are made, and what risks may apply.
At True North Wealth Management, we help clients evaluate investment options within the context of their full financial picture, including income needs, tax planning, risk tolerance, and long-term goals.
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Disclosure: Municipal bonds are subject to risks, including interest rate risk, credit risk, market risk, inflation risk, liquidity risk, and call risk. Some municipal bond income may be subject to federal, state, or local taxes, and certain bonds may be subject to the alternative minimum tax. Diversification does not guarantee a profit or protect against loss. Investors should consult with a qualified financial professional before making investment decisions.
Mutual funds are sold only by prospectus. Please consider the charges, risks, expenses, and investment objectives carefully before investing. A prospectus containing this and other information about the investment company can be obtained from your financial professional. Read it carefully before you invest or send money.
- Wikipedia.org, 2024
- SEC.gov, 2024. A municipal bond issuer may be unable to make interest or principal payments, which may lead to the issuer defaulting on the bond. If this occurs, the municipal bond may have little or no value.
- Municipal bonds are free of federal income tax. Municipal bonds also may be free of state and local income taxes for investors who live in the area where the bond was issued. If a bondholder purchases shares of a municipal bond fund that invests in bonds issued by other states, the bondholder may have to pay income taxes. It’s possible that the interest on certain municipal bonds may be determined to be taxable after purchase.
- Diversification is an approach to help manage investment risk. It does not eliminate the risk of loss if municipal bond prices decline.
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by FMG Suite to provide information on a topic that may be of interest. FMG Suite is not affiliated with the named broker-dealer, state- or SEC-registered investment advisory firm. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Copyright FMG Suite.