If you’ve been reading along you will know we have covered an overview of muni bonds as well as the benefits of muni bonds and the associated risks. But of course muni bonds aren’t your only option when it comes to growing your money. As an investor, you’ve got plenty of choices, from stocks to a host of options insured by the FDIC. Let’s see how muni bonds stack up against the competition.
Why invest in munis instead of stocks or a savings account?
Though municipal bonds are considered to be a relatively safe investment, if you’re looking for absolute peace of mind, it doesn’t get any better than an account that’s insured by the FDIC. Savings accounts, certificates of deposit (CDs), and money market accounts are all federally insured up to $250,000 per depositor. (If you open a joint account with a partner, you’re covered up to $500,000.) Stay within this limit, and you’re guaranteed not to lose a penny regardless of how the market performs or how the economy fares on a whole. Municipal bonds, however, don’t always offer that same assurance. While some municipal bonds are insured, some may be insured less than dollar for dollar and many have no insurance at all, which means loss of principal can’t be ruled out in the event of a default.
When comparing muni bonds to FDIC-insured accounts, there are four factors to consider:
- Interest rates
- The term, or length, of each investment
- The minimum investment required
Municipal bonds offer much higher interest rates than their FDIC-insured counterparts. On top of that, the interest earned from munis is exempt from federal income taxes, whereas interest earned from CDs, savings, and money market accounts is taxed as ordinary income.
Muni bonds — at least those with the highest yields — are also usually more of a long-term investment than CDs, money markets, and savings accounts, though there are no penalties for selling off your muni bonds before they mature. Keep in mind though, if you make a profit on the sale of your bond, you’ll have to pay capital gains taxes, but that’s not considered a penalty. With CDs, you’ll pay a penalty for early withdrawal — typically three months’ worth of interest for a one-year CD or six months’ worth of interest for a CD with a longer term.
Despite the penalties involved in cashing out a CD before its term is up, CDs are still considered to be far more liquid than municipal bonds, as are money market and savings accounts. That’s because you can easily withdraw money from a CD at any time without having to worry about losing principal, and the same holds true for savings accounts and money markets. (There are some withdrawal limits and related penalties for money market accounts, but if you plan accordingly, these shouldn’t come into play). With municipal bonds, your principal is tied up for the term of the bond, and while you can technically choose to sell at any time, doing so could result in a loss if market conditions aren’t favorable. Even if you are willing to take a loss on your munis, it may take some time to find a buyer.
Though muni bonds aren’t as liquid as CDs, money markets, and savings accounts, all of these options generally come with minimum investment requirements. For a savings account, the minimum can be as low as $100 depending on the institution. CDs and money markets typically require a $1,000 minimum investment, though the ones offering the best rates may have higher thresholds. Muni bonds, by comparison, usually have a $5,000 minimum (though we are working to lower those requirements to allow more people to invest locally).
Muni Bonds vs. Stocks
Like corporate bonds, municipal bonds work differently than stocks. When you purchase shares of a stock, you’re not lending a company money in exchange for interest; rather, you’re purchasing an equity share in the company. If the company makes money, you stand to profit from its earnings. But if the company performs poorly, you won’t see those sought-after dividends.
Muni bonds, on the other hand, pay a fixed amount of interest regardless of how the entity in which you’ve invested performs. Let’s say you decide to invest in a local construction project, and the project is plagued with extensive delays coupled with higher costs and lower revenues than initially anticipated. As a bondholder, none of that needs to matter to you as long as your scheduled interest payments keep coming in. The keyword in the previous sentence is as long as because if the bondholder defaults, you will not receive your interest payment.
While the payment structure of muni bonds may work to generate a more reliable, steady stream of income, stocks have historically performed better on a whole. Many financial experts agree that you can expect to earn 7% a year on stocks over the long haul, whereas the average yield on municipal bonds has been just over 4%.
Another thing to keep in mind is that muni bonds may cost more to purchase than stocks. Munis are generally sold at a markup, so instead of paying your broker a commission upon purchase, you’ll pay a higher price altogether. In fact, some SEC research suggests that the cost of trading muni bonds is significantly higher than that of stocks.
Weighing Your Options
When it comes to both risk and reward, municipal bonds can be a solid middle ground option in the grand scheme of investing. Though they aren’t as secure as CDs, money markets, and savings accounts, they’re typically far less volatile than stocks, and their average historical return reflects these risk-related tiers. In our next section, we’ll compare munis to corporate bonds to give you a good sense of how they rate. In the meantime, if you’d like to learn more about how they work, visit Neighborly and explore the local opportunities available to you.