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What to Look For in a Municipal Bond

Municipal bonds, like corporate and federal government bonds, are rated by the major bond-rating agencies. For many years, munis had their own rating system. Recently, however, the rating systems have been unified.

You definitely want munis that are rated. Some municipal offerings are not rated, and these can be risky investments or very illiquid (you may not be able to sell them when you want, if at all). If you are an average investor, go mostly with the top-rated munis: Moody’s AA or higher.

The lower-rated munis may give you a bit extra yield but probably aren’t worth the added risk, except perhaps for a limited portion of your portfolio.

Keep in mind that a lower-rated bond can be more volatile than a high-rated bond. Default isn’t the only risk. If you suddenly need to cash out the muni part of your portfolio, and high-yield munis are in the tank, you may not have access to much of your cash.

As for the insurance guarantee offered on so many munis today, as long as a muni has a high rating and is a general obligation muni (not a revenue muni), consider going without the insurance for that possible drop of extra juice. General obligation bonds generally don’t default. On average, there’s been only one such default each decade.

If you’re looking for even more safety in a muni than a top-rated general obligation bond, you can try to find a pre-refunded municipal bond. That means the municipality put money aside into an escrow account to ensure payment to pay bondholders.

If the money in escrow is held in U.S. Treasuries, then your investment is backed by the federal government. Of course, great safety means low yields. Pre-refunded bonds are not going to give you quite the same interest rate as other munis. Still, you’re going to get a higher return than you would on Treasuries.

You also want to choose a municipal bond that carries a maturity you can live with. (Most pre-refunded bonds have short maturities.) If the bond is callable, well, is that something you can live with and still be happy? Callable bonds pay slightly higher coupon rates but are less predictable than noncallable bonds.

Of great importance in choosing munis are clearly their tax benefits, which can vary. Do you want a muni that is merely free from federal income tax, or do you want a muni that is double- or triple-tax-free? (Note: Some munis, called Build America Bonds, or BABs, are entirely taxable.)

Here’s the scoop:

  • National munis are exempt from federal tax but are not necessarily exempt from state income tax. (Some states tax bond coupon payments, and others do not.)

  • State munis, if purchased by residents of the same state, are typically exempt from state tax, if there is one. Some, but not all, state munis are also exempt from all local taxes.

  • Munis that are exempt from both federal and state tax are called double-tax-free bonds. Some locally issued bonds may be exempt from federal, state, and local tax; these are often referred to as triple-tax-free bonds.

  • Munis issued by Puerto Rico and Guam are free from federal and state taxes, regardless of where you live.

You need to do a bit of math to determine which kind is better for you: national or state, double- or triple-tax-free. Consult your tax adviser before laying out any big money on munis. The tax rules are complicated and forever changing.

Some states — but not all — impose taxes if you invest in states other than your own, but others may even tax you on munis issued by your own state. Bonds issued in Puerto Rico and other U.S. territories carry their own tax peculiarities. It’s a jungle out there!

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