Municipal Bonds: What You Need to Know Before Investing | American Funds

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Mutual Fund Basics

Municipal Bonds: What You Need to Know Before Investing

Municipal bonds are fixed-income securities issued by local and state governments to raise capital for spending on infrastructure, special projects or other general needs.

Unlike corporate bonds, the income that munis (an abbreviated term often used to describe these securities) generate is generally exempt from federal, and sometimes, state and local income taxes.

Investors can either buy munis directly or purchase shares of mutual funds that invest part or all of their assets in them. Credit quality varies widely across the universe of municipal bond issuers. In today’s market, most municipal bonds are rated below triple-A, the highest credit rating generally reserved for issuers with exceptional creditworthiness. Bond ratings, which typically range from AAA/Aaa (highest) to D (lowest), are assigned by credit rating agencies, such as Standard & Poor’s, Moody’s and/or Fitch, as an indication of an issuer’s creditworthiness. Lower rated bonds tend to offer higher yields because of the risks involved. Diversification can be a useful strategy to provide investors with ample potential yield, while mitigating the risks associated with holding a single security.

Potential Benefits

  • Municipal bonds provide the unique advantage of generating income that is exempt from federal and, in some cases, state and local income taxes (although some municipal securities may be subject to the Alternative Minimum Tax). This can be attractive for investors in a high tax bracket.
  • Because few munis now carry triple-A ratings, their yield can be similar to that derived from corporate bonds.

Potential Risks

  • For many years, insurers backed a large proportion of municipal bonds, which were often given triple-A ratings as a result of the insurance. Most bond insurers left the muni market after the global financial crisis in 2007 and 2008, so in today’s market, credit risk has become a much more significant consideration.
  • Because municipal bonds tend to have lower ratings and are traded over the counter, meaning they are traded through a dealer network rather than on a formal exchange, they can be harder to sell. So, buyers often demand wider bid-ask spreads (the difference between the price that buyers are willing to pay and sellers are willing to accept).

Reasons to Consider

  • The tax-exempt income that municipal bonds generate may be attractive to many investors, particularly those investors in higher tax brackets.
  • Municipal bonds can add diversification to a stock portfolio, as municipal bond prices have tended not to move in concert with stock prices. In other words, municipal bond prices have often been relatively stable during stock market declines.

 


Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.