Investing in Municipal Bonds Now

Is now a good time to be investing in municipal bonds? Also known as muni bonds, municipal bonds are bonds issued by state and local governments. Typically, these bonds are used to finance government operations or capital investments for various local and state government agencies. Like corporate bonds, muni bonds pay interest and return your principal at the end of the bond’s term.

Should You Invest in Municipal Bonds Now?

Municipal bond investment graphicMunicipal bonds are a great investment opportunity that goes largely unnoticed by most non-professional investors. Muni bonds are safer than stocks over a long period of time and can offer significant tax advantages. When investors do take advantage of investing in muni bonds, it is often via muni bond funds which offers a very different investment experience than investing directly in actual muni bonds.

So, is now a good time to invest in munis?

Like all bonds, the price of muni bonds moves in the opposite direction of interest rates. That is if interest rates rise, bond prices fall. The Federal Reserve’s benchmark interest rate is currently at zero, which means that the part of bond pricing that is attributable to interest rates can only go down.

In essence, bond prices are going to fall when interest rates go up, and there is nothing you can do about it.

Does this mean that now is a bad time to invest in municipal bonds?

No. It means that now is a bad time to invest in municipal bond funds, but it is not necessarily a bad time to invest directly in muni bonds.

To understand the difference it is important to remember how a bond works. For simplicity sake, let’s assume that an investor purchases a municipal bond from a state government agency for $1,000. The bond pays 5 percent interest, and matures in five years. In this scenario, the investor receives $25 every six months in interest payments. (Five percent of $1,000 is $50, paid semi-annually, or $25 every six months.)

More importantly, the investor receives his initial $1,000 investment back when the bond matures in five years.

Just like a muni bond fund, the current value of this municipal bond will rise and fall over the next five years. If interest rates rise, the price the bond can be sold for will decline. However, the key is that if the investor does not sell the bond, then he will get his $1,000 principal back regardless of what direction interest rates move in.

Contrast this to a muni bond mutual fund, which is composed a portfolio of numerous muni bonds. While some of the bonds will mature and return their principal, others may be sold before their maturity date. More importantly, the fund will not have all of its investments mature at the same time, so no matter when an investor sells, some of the bond’s values will have decreased due to rising interest rates.

Not to put too fine of point on it, but a muni bond mutual fund investor is almost guaranteed to lose principal when interest rates rise. The only way for a muni bond fund investment to be profitable over short-term is for the amount of interest earned to exceed the amount the value of the fund will decline. With interest rates on munis running very low, this is very difficult to achieve without taking on significant risk.

In other words, now is a bad time to invest in muni funds, but it may be a fine time to invest in muni bonds.

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