Even if you’ve never bought a municipal bond before, if you have an investment account, there’s a good chance you have some muni bonds sitting in your portfolio.
But what if you’d like to invest in a specific public project, place or sector by buying an individual muni bond directly?
You might think that because a muni bond fund is a collection of individual muni bonds, it would behave pretty similarly to owning those bonds individually. But from an investment perspective, bond funds can react very differently to market changes. “There is a huge difference between bond funds and individual bonds,” said Scott Colyer, CEO and chief investment officer for Advisors Asset Management on CNBC. “Some suggest that they’re not even the same asset class, because bond funds react so differently to market forces.”
Let’s take a look at the difference between investing in an individual muni bond and a muni bond fund.
Individual Muni Bonds
Get your money back at maturity
When you buy an individual muni bond, the issuer promises to return you your original investment when the bond matures. “The advantage of buying individual bonds is that you’ll get all your money back at maturity, assuming the issuer doesn’t default,” according to Bankrate. Fortunately for investors, defaults on muni bonds are exceedingly rare. As finance writer David Waring notes in Learn Bonds, “Historically, municipal bonds are between 50 and 100 times less likely to default than corporate debt with the same rating.” A muni bond fund investment makes no promise to return your original investment, so the value of your investment could go down as well as up, even if none of the issuers whose bonds are in the fund have actually defaulted.
If you own individual municipal bonds, your returns are agreed up front, so you know what returns to expect. The value of a municipal bond fund, and therefore its returns, are dependent on investor demand for the fund, however. That means if other investors in the same fund as you withdraw their investments, the value of your investment may go down. “By owning individual munis, your worries about other investors panicking, then rushing out of bonds funds (as they did a year ago) won’t affect your portfolio value,” says Marilyn Cohen, president of Envision Capital Management.
You have to oversee diversification and manage risk
Having a portfolio that is diversified according to your specific needs and manages risk appropriately is very important. If you’re investing in a small number of individual municipal bonds, it’s up to you to spread your investments across a diverse range of assets. For instance, you could do this by buying a range of different municipal bonds, from different issuers and in different sectors, or you could balance investments in individual municipal bonds with other assets, like stocks or commodities. “Investor[s] must purchase many bonds from multiple issuers and maturities to achieve diversification—which means it may require a significant investment to achieve diversification,” according to Fidelity Investments.
Buying individual munis might be complicated or expensive
As we’ve noted many times before, buying individual municipal bonds as an individual investor can be difficult. Often bonds are denominated at $5,000, which means you need at least that much to invest each time. It can also be expensive due to fixed fees that some brokers charge. Of course, this is one of the reasons we founded Neighborly – to make buying bonds simple and cost effective. Investing in a fund means the fund takes care of that piece for you, for a fee (see below). “The fund can buy wholesale while individuals have to buy retail, which typically is more expensive,” says Jason Zweig of The Wall Street Journal.
Muni Bond Funds
Researching individual muni bonds can be challenging if you’re new to the market. A muni bond fund is managed by a financial professional who does this research for you. It’s one of the reasons why funds charge management fees. “It’s a market where investors can benefit from professional advice, as long as the advisers are experienced and don’t charge too much,” says Tim Ghriskey, co-founder of the Solaris Group.
As noted above, diversifying your portfolio takes some planning. Investing in a fund means this work is done for you. “Risk is spread out across many different types of investments and the fund is managed by a professional,” says finance writer Dan Moskowitz.
Many municipal bonds trade infrequently after they’re first issued, so if you’d like to sell your bond before it matures, you are not guaranteed to find a buyer right away. Funds, on the other hand, are a very liquid market and you can typically sell out of your investment at any time.
Lack of choice and focus
If you’re excited about investing in your local school district’s latest fundraising because you want to have a stake in local economic development, you won’t be able to do so with a fund. Even if you know the district’s finances very well and have done your research, you can’t ask your fund manager to buy a specific bond on your behalf. Even if your fund happens to be invested in your local district at one moment in time, there’s very little to prevent the fund manager selling those bonds at any point. You can choose a fund that gives you a focus at a much higher level, such as investing in California municipal bonds, but that’s about as close to local investing as you’re likely to find.
Because funds do the work of trading on your behalf (as described earlier), they charge fees. Always check the fee structure for any fund you are considering as these may vary significantly. For instance, Forbes reviewed the fee structures for three municipal bond funds and found that depending on the amount you’re investing, your fees may vary a lot.
Returns are variable
Because bond funds can fluctuate in value based on investor demand, they don’t offer the fixed returns that individual bonds do. It’s not possible to lock in a certain interest rate for the life of your investment, as you can with an individual bond. You can research the fund’s previous performance to get a sense of what returns investors in that fund have been receiving, but as with any investment, past performance is no guarantee of future returns.
Default risk still exists
Just because you are paying for professional oversight of your investment, a bond fund is not risk free. As Morningstar notes, “some municipal-bond funds are vulnerable to credit problems and bond defaults. (That is, the issuers of the bonds they own could fail to pay up on their obligations.)” The higher the credit rating a fund has, the less likely it is to end up in this situation, but the risk is never zero.
The Bottom Line
Choosing whether to invest in an individual muni bond or a muni bond fund is an important choice and should be driven by your experience, investment goals and the time horizon over which you’d like to invest. Understanding the potential risks and rewards of both investment paths can help you make better choices. Read more on the Neighborly Learning Center about the many ways muni bonds can help your portfolio as well as your community.