Municipal bonds pay a lower rate of return than most other types of bonds, including T-bonds, T-bills, and corporate bonds. However, because of their tax-favored status, the relative after-tax return municipal bonds offer would still be nearly as good as - if not better than - many other bonds (depend into your tax bracket). High-quality municipal bonds yield about 15 percent less than comparable government securities, so if you're in the 15-percent tax bracket, or higher, your relative return with municipal bonds could be as high as T-bonds and T-notes (or higher, depending on your state tax status).
As with most types of bonds, interest rates for municipal bonds can vary greatly from year to year. Since 1925, municipal bonds have provide an annual return of about 4.2 percent, compared with a average return of 5.3 percent for T-bonds, 5.8 percent for corporate bonds, and 10.7 percent for stocks. Generally speaking, the longer the term of the municipal bond, the higher the return you would receive. .
Municipal bonds are considered very safe, but not as safe as U.S. Treasury securities, such as T-bonds, T-notes, and T-bills. Municipal bonds have been known to default on rare occasions. To play it safe, you should have a diversified selection of municipal bonds in your portfolio. Some advisors suggest that you may need $100,000 or more in municipal bonds to create a properly diversified municipal bonds in portfolio.
If that sounds like more than you can afford, there are two other ways to lower your risk. You could try buy a municipal bond mutual fund. There are a number of specialized funds available from some of the leading mutual fund companies.
The other option is to buy insured municipal bonds. You can't actually buy insurance on your individual bonds, but you can buy bonds that already have insurance attached to them. About half of the bonds issued now have insurance available, but it does cut slightly into your return. Bond insurers guarantee bondholders that they will receive timely payment of interest and principal throughout the term of the bond.
Clearly the tax-exempt status of municipal bonds is their biggest and most important benefit. But there are several other important benefits, such as:
- Safety. Although they are not as safe as Treasury securities, municipal bonds are considered to be relatively safe investment.
- Income. Municipal bonds provide a steady stream of tax-exempt income.
- Liquidity. Municipal bonds can be bought and sold on the secondary market, giving investors an opportunity to unload their bonds if they need to cash out early.
- Easy to buy. Municipal bonds are easy to buy and can be purchased through your bank or your broker.
But, municipal bonds rates are not especially enticing, so they are not likely to show up in the portfolios of most aggressive investors. Another drawback of municipal bonds is that most of them are callable, so they can be redeemed early. If you're shopping for a municipal bond, find out how many years of call protection you'll receive. One more concern for municipal bonds owners is that the secondary market for some bonds is very thin, so you may have a little trouble selling out if you want to dump your bond early.
