Should You Buy Municipal Bonds In a Fund or Individually?

One of questions often asked about municipal bonds is whether they should be purchased individually or via a fund. I think it depends on your goal in purchasing municipal bonds.

One of questions often asked about municipal bonds is whether they should be purchased individually or via a fund.  I think it depends on the amount of money you have to invest and whether you are looking for income or for an investment.

First, let's start with an assumption about municipal bonds.  They are generally extremely safe.  Even during the great depression, fewer than 10 municipalities defaulted on their debt obligation.  States and towns have the option of raising taxes and cutting services before they default.  Municipals are considered much safer than their corporate bond cousins.  That safety only increases if you purchase municipals from towns, cities, and states that are not experiencing severe financial stress.

That means the need to diversify with municipals is not as great as with some other asset classes. 

This brings us back to the money question.  You should probably have a minimum of $10,000 before investing directly in municipal bonds.  If you have less, or want to invest periodically, then investing in a muni bond fund may be the way to go.

Second, you should decide if you are purchasing the municipal for its income or as an investment.

Purchase for Yield and Income

If you are purchasing for yield, the best thing you can do is buy a municipal bond and hold it to maturity.  That way, you are guaranteed the interest payments and the return of your principal upon maturity.  Other than the initial broker purchase fee, there are also no other fees.  Doing this, provides a steady stream of dependable, tax-free income and minimizes the chances of losing principal. 

Purchase as Investment

If you want to purchase municipals as part of your investment portfolio, buying into a muni fund might be a better option.  Muni funds rise and fall just like equity mutual funds and ETFs based on interest rates.  If the rate on new municipals is higher than it was when you purchased into the fund, the fund value will come down (what you own is worth less because it must compete with higher paying bonds).  Conversely if you invested at a rate higher than what is currently being offered, your fund will rise in value.  Like all bonds, the value of municipal bond rise and fall inversely to interest rates.

This explains why right now is the best and worst times for municipals.  If you hold individual municipals and plan to keep them to maturity, your real return has gone up over the last year as inflation has dropped.    If you also want to buy a new municipal it is a great time because rates on new issues are high.  You can purchase a municipal bond with a tax free equivalent of 8% or more.   

But if you have been investing in a municipal bond fund, you're feeling the pain.  According to the WSJ:

"Last year, long-term national muni funds lost an average of 9.4% as the financial crisis battered the bond insurers that had enabled roughly half of all munis to be rated AAA. Ten funds, according to Morningstar, fell by at least 15% each -- a shocker in an investment category that has had a negative return in only four out of the past 25 years."

Either way, municipal bonds are an asset class that offer solid opportunities for savers and investors.

Sam Cass
Sam Cass: Sam Cass, MBA, JD, University of Texas at Austin. Always a fan of Leonardo Da Vinci.

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