Although all the talks at dinner parties are around the hot stocks, the role of mutual bonds in a diversified portfolio cannot be overstated.\r\n\r\nThe advantage of bonds is that they zig when stocks zag. \r\n\r\nWhen everyone gets nervous and shook out of stocks they run to the safety of bonds. \r\n\r\nAlso because bonds pay interest we have the ability to reinvest quick and actively manage duration and risk exposure. But that\u2019s advanced let\u2019s start with some background.\r\n\r\nEven within the bond world, most people want to discuss corporate bonds, but when you are trying to diversify your portfolio one should pay careful attention to the options available outside the corporate world. \r\n\r\nMunicipalities like townships, counties, states, Regions issue attractive debt instruments. Specifically, there\u2019s a large market for investing in municipal bonds, or \u201cmuni\u201d bonds.\r\n\r\nWhat makes these offerings attractive is not only their interest rate terms, but their tax advantage, and low correlation to the stock market.\r\n\r\nSpecific to the question of whether they are good for a retirement account, the direct answer is \u201cNo, not really.\u201d The high return to risk is best recognized in a taxable account because of tax advantages received. Let\u2019s continue to explore.\r\n\r\nLet\u2019s talk about the different types of municipal bonds (revenue vs. general obligation), the tax benefits, and how to choose the right bonds for your portfolio.\r\nThe Story Behind Municipal Bonds\r\nMunicipal Bonds Investment\r\n\r\nNew York City was the first community to issue a bond in the year 1812 and the proceeds were used to pay to dig a canal.\r\n\r\nSince this first issuance the municipal market has increased to 4 trillion.\r\n\r\nMost of the notable infrastructure build throughout the United States was funded via municipal bonds. \r\n\r\nSt. Louis Arch, Seattle Space Needle, Golden State Bridge, etc.\r\nHow municipal bonds work\r\n\r\nWhen you buy a bond, you\u2019re agreeing to invest a lump sum of money, known as the principal, over a fixed duration of time. \r\n\r\nThe city, county, state that issues the instrument agrees to pay back both the principal when it comes due (Maturity Date), and to make interest payments to you over that holding period.\r\n\r\nAs an example, you buy a 7-year, $10,000 bond paying 8% interest.\r\n\r\nThe issuing municipality, in return, will promise to pay you interest on that principal every six months at 8% and then return your original $10,000 once that 7-year period has elapsed.\r\n\r\nThe difference with Municipal bonds is that they are always exempt from federal taxes.\r\n\r\nThis advantage also applies when you buy bonds issued by the state you live in, your interest payments are exempt from state and local taxes as well.\r\n\r\nIt definitely pays (literally) to invest locally.\r\nTypes of municipal bonds\r\n\r\nMunicipal bonds come in two varieties: general obligation bonds and revenue bonds.\r\n\r\nGeneral obligation bonds fund projects not linked directly to a defined revenue stream. \r\n\r\nRevenue bonds, of course, have a direct tie to the revenue stream they are help creating, augmenting.\r\nGeneral obligation bonds (GOB)\r\nGENERAL OBLIGATION BOND\r\n\r\nWhen a city issues a GOB it is backed with the \u201cfull faith and credit of the issuer.\u201d\r\n\r\nThis specifically means that independent of how the funds were used the city remains obligated to make the investors whole.\r\n\r\nBecause of this broader obligation the default risk on these instruments has been materially lower than Revenue bonds. \r\n\r\nWith that being said, it is still important to review the credit worthiness of each city before you make an investment.\r\nRevenue bonds (RB)\r\nRevenue Bond\r\n\r\nRevenue bonds are different. \r\n\r\nThey issued to finance specific projects that have the potential to make money.\r\n\r\nWhereas general obligation bonds are backed by the full faith and credit of the issuer, revenue bonds are backed by the income streams they\u2019re tied to.\r\n\r\nAn investor should start their due diligence not on the credit worthiness of the city but rather the merits of the individual project. \r\n\r\nRevenue bonds have a higher default rate than GBOs, but also have a higher return, in general, to help off-set the risk.\r\nHow to invest in municipal bonds\r\nSecurities Rulemaking Boards\r\n\r\nMunicipal bonds are a little more difficult to invest in than a stock or corporate bond. \r\n\r\nThere is not a market exchange set to provide a ready exchange between cities and the public. \r\n\r\nThese deals are conducted directly between two private parties.\r\n\r\nIf you want to purchase individual municipal bonds, you\u2019ll need to find an individual who can locate the bonds, or you find them directly online, and find someone interested in selling their holding. \r\n\r\nHowever, be careful if you are going through a broker. Because these funds have a different regulatory structure there\u2019s the opportunity for transactional fees to get very high. \r\n\r\nThe oversight organization is the Municipal Securities Rulemaking Board (MSRB), which governs the muni bond market.\r\n\r\nThey do establish disclosure rules so you can orient yourself to those details before investing.\r\n\r\nYou can purchase municipal bonds through different instruments. One way is to buy shares of a Muni-bond mutual fund. \r\n\r\nIf you go this route you will get instant diversification across many communities, many projects, and different durations. If one city or one project goes bad, you\u2019ll have many others to help cover the loss.\r\n\r\nExchange-traded funds (ETF) are also available in this space and serve the same purpose and have lower fees. \r\n\r\nETFs are typically a much efficient vehicle and can be more tax efficient. I-shares has an ETF with a ticker symbol MUB that is my default choice.\r\n\r\nIf you are going to build a large portfolio of Muni-bonds I would at Schwab\u2019s market place and consider opening an account with them. Here\u2019s an overview of their offering. \r\nBenefits of municipal bonds\r\nMunicipal Bonds\r\n\r\nThe principle benefit is tax avoidance. These offerings are always exempt at the federal level, and can also be exempt at the state and city level.\r\n\r\nAnother benefit of buying municipal bonds is that the risk of default is minimal, making them a relatively secure investment.\r\n\r\nBetween 1970 and 2019, there were only 104 defaults on record among the many thousands of munis issued \u2014 and only 9 general obligation bond defaults. \r\n\r\nIf you go with the highest rated cities, the default risk is further reduced. From a statistical perspective a Muni-bond is 100 times less likely to default than corporate issuances with equivalent risk ratings.\r\n\r\nThe final benefit is more tactical. If you live in the community that you are investing in, you can watch dollars improve your community. That can be a tremendous feeling.\r\nHow to Pick the Right municipal bonds\r\nTax Free Bonds\r\n\r\nBecause the primary benefit of Muni-bonds is the tax avoidance on interest earned, you\u2019ll want to first investigate the tax savings available to you based on where you live. \r\n\r\nNext, you need to do your due diligence and check the creditworthiness of the community or project issuing the bond. \r\n\r\nThere are three sources that rank issuers based on their likelihood of meeting their financial obligations versus defaulting on them (Standard &amp; Poor\u2019s (S&amp;P), Moody\u2019s, and Fitch).\r\nConclusion on benefits of municipal bonds\r\n\r\nMunicipal bonds let you invest in projects that build and better communities.\r\n\r\nThey also offer an opportunity to secure a steady stream of interest income without exposing yourself to undue risk.\r\n\r\nThat said, they aren\u2019t for everyone, so it pays to weigh their advantages against their drawbacks to see if they belong in your portfolio.\r\n\r\nIf you do decide to invest in munis, be sure to research your bonds thoroughly, in terms of both your issuer\u2019s credit rating and the price you\u2019re being quoted for your bonds.\r\n\r\nThe more educated a decision you make, the more likely your investments are to pay off the way you want them to.