The last several years have seen significant changes in the bond markets, and municipal bonds issued by local state and city governments have not been immune. However, with the Fed likely to hold interest rates or gradually begin to cut them over the next year, bonds present a promising opportunity for financial growth. Given the unique advantages of municipal bonds, we will focus on why now may be the right time to consider these quintessential investments for your retirement portfolio.
What is a municipal bond?
Municipal bonds, often called munis, are debt securities similar to US Treasuries but issued by local state, county, and city governments to fund projects.Â
Often, municipal bonds are tax-exempt, meaning interest payments are exempt from ordinary federal and local income taxes. This tax-exempt status is not just a financial benefit, but also a way to encourage investors to contribute to the development of their local communities. The reason for this is to spur investors to loan money to local governments so that they can fund projects and goals that may otherwise not receive funding. Common examples of where muni funds may go are towards constructing new schools and improving bridges or roadways. Generally, for a muni bond to be tax-exempt, the investor must live in the state where the muni is issued.
Some munis are short-term, meaning they repay the original principal to an investor within one to three years. Still, others are longer-term and can pay interest for ten, twenty, or thirty years before they repay the borrowed amount.
Types of munis
Muni bonds come in two primary flavors: general obligation and revenue bonds.Â
General obligation bonds refer to issuances backed by a local government's credit and its ability to raise taxes.
Revenue bonds refer to issuances backed by revenue generated by a project, such as a toll road or stadium.Â
Risks posed by munis
Munis are similar to other bonds in that the risk of default comes from the issuer's creditworthiness or the project's revenue source. For example, state general obligation muni bonds are generally considered safe, while a small town that has defaulted in the past is a higher-risk issuer.
In addition to default risk, longer-term munis carry interest rate risk. This means that if interest rates rise dramatically, their immediate resale value could decrease if they are not held to maturity. Concurrently, if inflation trends are higher than usual, the muni holder could see the value of their holding erode.
Furthermore, like all bonds, munis face call risk, meaning they could be paid back by the issuer sooner than expected. If this happens, the muni holder does not receive the income payments expected for the initially intended period, requiring them to look elsewhere for income.
Lastly, suppose the muni is more obscure or from a smaller issuer. In that case, a muni holder may face liquidity issues if they need to sell their holdings before maturity since trading may be less frequent in this issuance compared to those from larger bond issuers.
Munis and retirement
Managing taxes and income in retirement is a top priority. Given the unique tax benefits of muni bonds, investors may want to consider creating a muni bond portfolio for the portion of their portfolio allocated towards safer investments.Â
While muni bonds generally pay less than corporate bonds, their real after-tax returns may be higher since their interest payments can be tax-exempt. Depending on the investor's retirement needs and if they already face a high tax burden, munis can become highly desirable compared to US Treasuries and corporate bonds.
Next steps
If you are nearing retirement or are already retired and are looking for ways to minimize your taxes while creating an income stream, we are here to help. At Lundeen Abrams Advisors, we consider each client's unique needs and are familiar with various strategies to generate income while minimizing taxes. If you are ready to meet with an advisor, please get in touch with us to schedule an appointment today. We will look forward to talking with you soon!