Municipal Bonds: When Should They Be Considered?

As you are putting together your emergency savings or saving/investing for a specific goal, one option that is often overlooked is municipal bonds.
Public borrowing is costly these days, true, but interest rates on municipal bonds are still considerably lower than those borne by corporate debt.
— Thomas Frank

Municipal bonds like their name suggests are bonds issued by municipalities (local and state governments) to pay for relatively large projects. They often have fairly low interest rates (low yield) but are tax advantaged. There are some differences between bonds funds and bond EFTs but for the purposes of this article bond funds refer to both bond funds and bond ETFs.

Risk

Municipal bonds like all bonds have better yields when the municipality is struggling and that correlates to higher risk. Although less risky, investing in a single bond is much like investing a single stock (personally I don't want all my eggs in one basket). An option to counter this risk is to invest in a municipal bond fund. You can usually liquidate the investment in the fund after 30 days without penalty but they tend to have high initial investment minimums of $2,500 to $100,000. The funds pay out monthly interest payments so you can cash out at anytime without losing out on possible interest. Municipal bond funds do require a little extra work as you would want to verify that the fund does not hold bonds that are at high risk of defaulting.

Taxes and Fees

The biggest selling point of municipal bonds is that the returns are tax free at the federal level and if the bonds are from the same state (you reside in) usually state income tax free as well. assuming you live in a state with an income tax, municipal bonds have about a thirty percent advantage over other investments. (25% federal income tax and 5% state income tax)

Like all investments, fees are your hidden enemy. You should find a fund that you can buy and sell with zero (or minimal fees) and then also one that has low management fees.

Conclusion

The table below shows how municipal bonds compete with other investments. I chose the high performers of each security for the table, you should expect results that are somewhat lower.

You can get better returns with a market fund however the short term risks are higher and you need to hold the investment for at least a year to avoid extra taxes.

Municipal bond funds can be held for as short as 30 days and offer tax free returns which can be appealing in certain personal situations. (e.g. emergency savings or a new car fund)

Full disclosure: At the time of this writing I held positions in at least one municipal bond fund