Are you thinking of investing in municipal bonds? If so, you may have good reason, particularly if you are in one of the higher tax brackets.

After all, municipal bond interest payments typically are exempt from federal income taxes, and possibly state and local income taxes, too — although some “munis” are subject to the alternative minimum tax. However, since not all municipal bonds are the same, you’ll want to know the differences — especially in terms of risk.

Municipal bonds, like corporate bonds, essentially face two types of risk: interest rate risk and default risk. Interest rate risk becomes clear when market interest rates rise, causing the value of your existing municipal bonds to fall. No one will pay you full price for your bonds when newly issued bonds carry a higher rate — so if you plan on selling bonds before they mature, you risk losing principal. You can largely ignore this type of risk simply by holding your bonds until maturity, at which point you will receive the face value back, provided the issuer doesn’t default.

And that brings us to the second type of risk: default risk. Historically, municipal bond default rates have been much lower than those of corporate bonds, particularly lower-quality bonds. But different types of municipal bonds carry different levels of default risk. Here’s a quick look at the two main categories of municipals and their risk characteristics:

4 General obligation bonds — generally finance projects of a municipality. A general obligation bond issuer is required to do everything in its power, including raising new taxes, to ensure that interest payments are paid on time and in full. This requirement helps support the creditworthiness of general obligation bonds.

4 Revenue bonds — which finance schools, hospitals, utilities, airports, affordable housing and other public works, are paid by dedicated streams of revenue. For example, revenues generated by the sewer system pay the interest on a sewer system revenue bond. Because revenue bonds have more restricted revenue streams than general obligation bonds, they are generally viewed to be riskier. To compensate for the added risk, revenue bonds usually pay a higher rate of interest than general obligation bonds. When studying the risk factors of revenue bonds, you also have to consider the type of revenue bond involved. For example, some sectors, such as housing and health care, may be more volatile, as are some industrial revenue bonds. (These bonds, which are generally used to support a specific project, such as a new manufacturing facility, are sponsored by a government entity — but the proceeds go to a private, for-profit business.)

Of course, when evaluating the risk potential of municipal bonds, you don’t have to rely on guesswork. The major bond rating agencies — Standard & Poor’s, Moody’s and Fitch — review municipal bonds to determine their creditworthiness. There are no guarantees, but by sticking with the bonds that are “investment grade,” you can help reduce the risk of owning a bond that goes into default.

Municipal bonds can be valuable additions to your portfolio. Besides providing income that’s free of federal taxes, these bonds offer you a chance to help support valuable projects in your community. But, as we’ve seen, different “munis” have different risk factors — so make sure you know exactly what type of bond you’re purchasing before you write the check.

 

Tommy McDonald is an Edward Jones financial advisor.