Ever wonder where those couple of bucks go when you pass through a toll booth? How about when you go to the airport and pay to park? Or what about when you go to a hospital and pay for surgery—where’s that money go? Well, it’s very likely that a portion of that money flows back to investors holding municipal bonds. That’s right, the couple of quarters you clink in the toll booth could be paying back people who loaned their money to state, city or county governments in exchange for interest and principal repayments. They’re counting on the change you find between your cushions!
But just what are municipal bonds and how do they work? More importantly, are they a part of a strong retirement strategy? Let’s dig in and see!
What Are Municipal Bonds?
A municipal bond, or “muni,” is a type of bond issued by a government entity (state, city or county) to fund public projects like the construction of schools, highways, hospitals and more. A bond is like an IOU—it’s a debt obligation. And with bonds, you are the one loaning the money to the issuer of the bond. So the issuer, in exchange for borrowing your money for a specified amount of time, promises (you know, like your word is your bond kind of thing) to pay you back the full amount plus interest along the way. Sounds like a pretty sweet deal, right? Maybe, maybe not.
How Do Municipal Bonds Work?
Say a state government wants to introduce toll roads across the state. But before the roads are outfitted for tolling, highways all across the state need to be repaired and have lanes added. The government estimates the project will cost $80 billion and take 10 years to complete. They’re $100 million short of budget so they decide to issue $100 million in municipal bonds to help close the gap. State taxpayers vote to make this possible.
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The state government issues bonds with a maturity date—the date the investor will get their original investment (or principal) back—for 10 years in the future. Bonds with a maturity date a decade or more in the future are considered long-term while those in the one- to three-year range are short-term. Over that 10-year period, you and all the other investors who loaned the state their money will receive interest payments at specified times along the way—think of it like a “Thanks for letting us use your cash for a while!” Because these are municipal bonds, you don’t have to pay federal income tax on the interest you earn. And in this case, but not always, the state won’t charge state income tax either.
This tax exemption is one of the primary reasons why investors are attracted to municipal bonds. But there are municipal bonds where that’s not the case, so you’ll want to find that information out before you go forward. You don’t want to end up with a 10-year investment that you thought wouldn’t be taxed but is.
The other reason people invest in municipal bonds is because they’re low risk. Not entirely risk-free, but pretty darn low risk. On the whole, compared to corporations issuing bonds, municipalities are much less likely to default, which means they’re not able to make their interest and principal repayments.
So with our toll road example, when the 10 years are up, you’ll get your original investment back, plus over that decade, you’ll have received tax-exempt interest payments. But loaner beware: In general, bonds are not known for their high yields (that’s bond talk for interest rate). It’s what makes them so low risk and unlikely to default. If you’re able to earn even 5% interest, you’d still be well below where we want to see you as you save for retirement.
Types of Municipal Bonds
There are two types of municipal bonds: general obligation bonds and revenue bonds. The difference between the two comes down to what the source is for their interest and principal payments. Let’s take a closer look at each.
General Obligation Bonds
General obligation bonds are the lower risk of the two types of municipal bonds. With a general obligation bond, the repayment of your bond is guaranteed by two things: tax revenue and the operating revenue generated by the project it’s funding. That makes for a lower risk of default because repayments come from total revenue, not just the project’s revenue.
There are two types of general obligation bonds:
- Limited-tax. This type of bond allows municipalities to raise property taxes for a certain time period in order to meet interest and principal repayments. In most cases, with limited-tax general obligation bonds, taxpayer approval isn’t required to raise property taxes.
- Unlimited-tax. Unlimited-tax bonds are like limited-tax bonds except that property tax could be increased up to 100%. Of course, in that situation, taxpayer approval would be required. (Good luck with that!)
Revenue bonds carry more risk than general obligation bonds. That’s because the source of their interest and principal repayments comes only from revenue generated by the project they’re funding. Revenue bonds can’t be paid back by tax revenue.
Let’s say the state issues revenue bonds for its toll road project, those bonds will only be paid back with money generated by the tolls. There’s more of a gamble that the project won’t make enough money to pay investors back, but again, municipal bonds are still a low-risk investment. Revenue bonds also typically come with maturity dates that may be 20–30 years in the future. That can be a long time to wait to get your initial investment back.
Pros and Cons of Municipal Bonds
Generally speaking, bonds are a tool investors use to protect their wealth not necessarily to increase it. Yes, as long as the municipality makes good on their bonds, you’ll still earn interest. But it won’t be as much as it could be if you parked your money in growth stock mutual funds. Let’s take a closer look at the pros and cons of municipal bonds.
Pros of Municipal Bonds
- Low risk
- Tax-exempt interest at the federal level
- Usually tax-exempt interest at the state and local level
- High liquidity, which means they trade easily
- An investment in your state or community
Cons of Municipal Bonds
- Risk of default
- Maturity dates may be multiple decades in the future
- Interest rates may not beat inflation
- Potential to earn more interest with other kinds of taxable bonds
Are Municipal Bonds Right for Me?
Yes, it’s true municipal bonds are low risk. But you know what follows low risk . . . low reward. This is your retirement we’re talking about. And we want to see you enjoying the retirement of your dreams! Unfortunately, it isn’t likely municipal bonds are going to be the best way to get you there. But the great news is, we’ve got a plan that works.
When it comes to saving for retirement, look no further than growth stock mutual funds earning 10–12% interest. Not only do you earn way more with mutual funds, but when you get the right mix going (growth and income, growth, aggressive growth, and international), you also cut down on risk.
A Retirement Savings Strategy That Works
It’s important that you understand where your money is going and why. Your retirement is up to you, but you don’t have to go it alone! Let one of our SmartVestor Pros help you figure out your retirement strategy. Trust us, they want to help you understand your options. This is what they live for! Let our SmartVestor Pros help you plan!
This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.