What Are Municipal Bonds?

Municipal bonds are issued by state and local governments to finance public projects like buildings and roads. At first blush, they are maybe not the most exciting investment.

But here's where they become interesting: These types of bonds provide tax advantages that can be especially beneficial to investors in higher tax brackets. In some instances (particularly if issued by a state or municipality in which you reside), muni bonds' income is not taxed at the state or local level, either. This is a big consideration if you live in a high-income-tax state, such as California, New York, or New Jersey.

These five questions can help you figure out if investing in municipal bonds would benefit you (and the best way to do it).

1. How big is the tax advantage? Though munis traditionally have lower yields than similarly dated taxable bonds, because of their tax advantages, their yields often compare favorably with those of taxable investments once the munis' tax benefits are factored in.

You'll have to perform a calculation to figure out which type of bond has the better payoff after you factor in the different types of taxes the muni bond is exempt from (federal, state, etc.). The higher your tax bracket, the higher your tax benefit. But even if you're not in the highest tax bracket, munis still sometimes offer an advantage.

Let's compare two bond funds--they both invest in high-quality bonds of similar sensitivity to interest-rate movements (discussed below). One big difference between them is how the income they pay out to investors is taxed:

Vanguard Intermediate-Term Investment-Grade VFICX is in the U.S. corporate bond Morningstar Category. It's a taxable-bond fund, which means the income it pays out is taxable to investors who hold the fund in a taxable account (such as a brokerage account).

Vanguard Intermediate-Term Tax-Exempt VWITX is in the intermediate muni-national category. It's a municipal bond fund that pays out tax-free income.

It seems like a no-brainer if you look at just the SEC yields on the funds: The taxable fund yields 1.49% and the muni fund yields 0.7%. Does the tax savings you get from the muni make up for that lower yield? (Spoiler alert: sometimes, but only for high-income investors, particularly those in high-income-tax states.)

For high-income investors, particularly high-income investors in high-tax states like California and New York, the money you save in taxes is much more significant and could put the muni option ahead. You can find out which bond or bond fund would be better given your own tax circumstances by plugging the numbers into a tax-equivalent yield calculator.

2. Should you buy individual bonds or bond funds? Another question some investors might have is whether it makes sense to buy individual municipal bonds versus muni-bond funds. If you buy individual bonds it's possible to sidestep the interest-rate volatility involved with investing in mutual funds; provided you buy a bond that does not default and hold until maturity, you will receive your interest and principal regardless of interest-rate fluctuations. (In theory, anyway.) With a bond fund, by contrast, the value of your investment and even the fund's yield can fluctuate, for better or for worse.

But it's unwise to derive a false sense of security from investing in individual bonds, said senior analyst Eric Jacobson. With the exception of Treasuries, bonds in most sectors (municipals, mortgage securities, and corporates) carry features and options that make the timing of principal return much less certain.

In addition, researching individual bonds requires investors to get under the hood of an issuer's credit risk and the individual bond's risk of default, which can be especially challenging when researching municipal issuers.

On top of that, trading costs for smaller trades can be prohibitively high. With the exception of Treasuries, Jacobson said, "Investors almost always have an advantage buying a mutual fund's portfolio of bonds rather than buying bonds directly."

3. Do you prefer lower volatility, or higher yield? Like other bonds, municipal bonds have credit risk. A bond's primary risk is that the issuer could default. Although defaults in the $4 trillion municipal bond market have historically been very low, they do happen.

Credit ratings are an attempt to gauge the financial strength of the issuer; ratings in the A ranges (Aaa, AAA, Aa1, AA, and A) are all considered high-quality bonds that are less likely to default.

BB and Ba1 ratings are considered lower-quality, or high-yield, bonds. High-yield bonds pay out more to compensate investors for their higher risk of default. It's also worth noting that high-yield bonds tend to have more price volatility than higher-quality bonds.

4. What is your investing time horizon? Muni-bond funds are offered in many of the same flavors as traditional bond funds--long-, intermediate-, and short-term.

Investors who have short-term investment goals or those who expect rates to rise would be better off choosing a short-term muni-bond fund. Here's why: Put simply, bond prices have an inverse relationship with interest rates, so rising interest rates can cause bond prices to fall. As a result, in a rising-rate environment longer-dated muni bonds will bear the brunt of the sell-off more intensely than shorter-term munis (and vice versa).

But in exchange for their safety, shorter-term bonds have lower yield and lower long-term returns. An investor with a longer time horizon can ride out this volatility and reap the higher potential rewards that longer-dated bonds offer.

5. How do you find a "good" municipal bond fund? Price is an especially important consideration with bond funds because the range of expected returns is narrower. Municipal bond funds with higher expense ratios find themselves at a return disadvantage. To overcome this hurdle, more expensive funds may invest in riskier issues to try to juice their return. Be sure you're not paying a higher price to take on more risk.

Morningstar Analyst Ratings can steer you toward low-cost, best-in-class funds. Funds that earn Analyst Ratings of Gold, Silver, or Bronze are expected to outperform their categories and their benchmarks over a full market cycle.

Premium Members can find Morningstar Medalist funds in municipal bond categories using our

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Have a question about money or investments? Drop us a line at The.ShortAnswer@morningstar.com.