Are Municipal Bonds Right for You? Key Questions Answered

In our latest webinar on municipal bonds, Adams Brown Wealth Consultants’ Jude Fox and Trent Woodcock shared their insights on how these tax-exempt bonds can be a powerful addition to your investment portfolio. 

Below is a deeper dive into the questions raised during the session, which should help you better understand how these bonds might enhance your portfolio. 

Q: How do municipal bonds work? 

A: Municipal bonds are debt securities issued by state, county or city governments to finance public projects such as schools, roads or hospitals. When you buy a municipal bond, you’re essentially lending money to the government entity in exchange for regular interest payments, which are often exempt from federal income taxes and potentially state taxes as well. 

Q: Why are municipal bonds attractive to investors? 

A: One of the biggest draws to municipal bonds is the tax-free interest income, which makes them particularly appealing for high-income individuals seeking to reduce their tax liability. But there are other key benefits too: 

  • Safety and Stability: While they’re not completely risk-free, municipal bonds are generally safer than many other investment options, such as corporate bonds or stocks. Since they are backed by state or local governments, they often come with a higher level of security. 
  • Income Generation: Municipal bonds provide predictable, semi-annual interest payments, which can be especially valuable for retirees seeking reliable income. 
  • Preservation of Capital: Compared to stocks, bonds—especially municipal bonds—are less volatile, which can help investors preserve their capital. 

However, it’s important to recognize that with lower risk comes lower potential returns compared to higher-risk investments. 

Q: Are there any risks with municipal bonds? 

A: Yes, just like any investment, municipal bonds carry risks. Some of the key risks to consider include: 

  • Credit Risk: This is the risk that the government issuing the bond might not be able to meet its debt obligations. While defaults on municipal bonds are rare, they can happen. 
  • Interest Rate Risk: Bond prices typically move inversely to interest rates. If rates rise, the price of existing bonds generally falls, and vice versa. 
  • Liquidity Risk: Depending on the market, it might be difficult to sell your bond at its full value before maturity. 

Understanding these risks can help you make a more informed decision when considering municipal bonds for your portfolio. 

Q: Are the rates on municipal bonds set at the time of purchase, or can they change over time? 

A: Municipal bonds typically offer a fixed coupon rate, meaning that the interest rate is locked in at the time of purchase. As one of our advisors, Trent, mentioned during the session, “the coupon, or annual yield received by the buyer, will generally not change over the life of the bond.” However, it’s worth noting that some bonds are callable, meaning the issuer can pay off the bond earlier than the stated maturity, which could affect the returns you expect​. 

Q: What is the difference between general obligation (GO) bonds and revenue bonds? 

A: There are two primary types of municipal bonds: 

  • General Obligation (GO) Bonds: These are backed by the full faith and credit of the issuing government. For example, when a school district issues a GO bond, the money to repay the bond often comes from tax revenue. 
  • Revenue Bonds: These bonds are repaid from the revenue generated by specific projects, such as toll roads, hospitals or airports. As Trent explained, “Revenue bonds usually carry a little bit more risk than GO bonds but may offer higher yields due to that additional risk”. 

Q: How liquid are municipal bonds? 

A: Liquidity refers to how easily an investment can be bought or sold. For individual municipal bonds, liquidity can vary significantly depending on the bond’s issuer. Bonds issued by larger municipalities, such as the state of Kansas, tend to be more liquid than those from smaller cities. As Jude pointed out, “The market for a bond issued by the State of Kansas is going to be much bigger than if the City of Victoria, KS, issues a bond.” On the other hand, municipal bond mutual funds generally offer daily liquidity, making it easier to buy and sell shares without concern​. 

Q: How do Kansas municipal bonds compare to bonds from other states? 

A: Kansas municipal bonds tend to be higher-rated but may be harder to find due to the state’s smaller population and fewer bond issuances. In comparison, states like California and Texas offer more bond options. However, as Trent noted, bonds from smaller Kansas cities might not always have a credit rating, which could make them riskier than bonds from larger issuers​. 

Q: How do I evaluate whether a municipal bond is a good investment for me? 

A: To determine whether a municipal bond is right for you, it’s important to compare its tax-equivalent yield to the yield of other taxable investments. The tax-equivalent yield allows you to see what yield a taxable bond would need to offer to match the tax-free yield of a municipal bond. This can help you determine whether a municipal bond is a better deal compared to, say, a corporate bond. 

For example, if a municipal bond offers a 5% yield and you’re in the 30% tax bracket, the tax-equivalent yield would be around 7.14%. That means you’d need to find a taxable bond offering more than 7.14% to outperform the municipal bond. 

Your marginal tax rate plays a big role in whether municipal bonds are a good fit for you. Generally, the higher your tax bracket, the more beneficial municipal bonds become. 

Questions? 

Municipal bonds offer a unique opportunity to earn tax-free income while supporting public infrastructure. Whether you’re in a high tax bracket or simply looking for a more conservative investment option, it’s worth exploring how these bonds might fit into your overall financial strategy. If you have any more questions or need assistance tailoring a bond strategy, contact an Adams Brown personal financial planner. 

AdamsBrown Wealth Consultants, LLC & Private Client Services do not offer tax or legal advice.  Always consult a professional regarding your specific situation.