Muni vs. Bond Funds: Better Together?


Investing in bonds adds stability to investment portfolios, especially during bear markets when stocks are losing money. If you only buy a single municipal bond, the lack of diversification creates unnecessary risk. Although municipal bonds have a very low historical default rate, even the highest rated municipal bond has the potential to default. For long-term bonds, diversification becomes more valuable because the risk of default is inherently higher.

KEY TIPS

  • If you only buy a single municipal bond, the lack of diversification creates unnecessary risk.
  • The most significant advantage of investing in bond funds is the reduction of the risk of default.
  • There are many municipal bond funds, so you can diversify without giving up the tax advantages of municipal bonds.
  • In the long term, bond funds are often a better option than individual municipal bonds.

A better solution may be to spread your funds over several individual municipal bonds. This requires a great deal of research and a significant amount of capital. Another option is to supplement investments in municipal bonds with investments in bond funds, which spreads your risk and allows you to maintain a steady stream of income.

Default risk

The biggest risk with municipal bonds is default, but you can limit this risk by checking the creditworthiness of the municipal bond. Also, if you see a high return on a municipal bond, it means higher risk. An additional tip is that general obligation bonds are safer than income bonds. With general obligation bonds, an issuer relies on taxes to pay the bondholder, and taxes can always be increased. With revenue bonds, the issuer is confident in the performance of toll roads, airports, hospitals, and other specific improvements.

For the lowest risk, choose general obligation bonds over income bonds.

The most significant advantage of investing in bond funds is the reduction of the risk of default. A bond fund is similar to a stock fund. Rather than diversifying across sectors and industries, a bond market mutual fund diversifies into short-term bonds, medium-term bonds, long-term bonds, government bonds, and corporate bonds. You can also invest in an ETF from a bond fund. There are many municipal bond funds, so you can diversify without giving up the tax advantages of municipal bonds. The risk of default is much lower when you invest in a bond mutual fund because the risk is distributed.

Short term versus long term

Short-term individual municipal bonds are usually sound investments. In the short term, an investor can simply look at the credit rating of a particular municipal bond to determine its risk. If a municipal bond with a maturity of less than five years is investment grade, it is very likely that the principal will be repaid. Also, investors are less likely to need the money for other short-term purposes. Therefore, it should be possible to buy a short-term municipal bond, collect interest, recover principal, and ignore price fluctuations.

In the long term, bond funds are often a better option than individual municipal bonds. For several decades, even prosperous municipalities can experience tough times and struggling credit ratings. Today, an investor cannot predict which individual municipal bonds will perform best. Worse, a longer duration makes bond prices more volatile and more vulnerable to credit quality problems. It is also less realistic to expect to have a municipal bond for 20 or 30 years. Bond funds help reduce default risk and increase liquidity, both of which can be more important in the long run.

The bottom line

If you limit your investments to a few municipal bonds, you face higher risk without compensation. However, municipal bonds have historically offered very low risk, reliable interest payments, and tax advantages. For the lowest risk, choose general obligation bonds over income bonds. However, both types of individual municipal bonds lack liquidity. Adding bond ETFs or bond mutual funds to your portfolio adds diversification, limiting the risk of default. Bond funds are also more liquid and their benefits are even greater in the long run. Finally, remember that municipal bond funds often offer the same tax savings as individual municipal bonds.

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Mark Holland

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