If you’ve been following our Beginner’s Guide to Municipal Bonds, you’ll know we have covered some bond basics, including the benefits of investing in muni bonds and the associated risks. But since all investment decisions are relative, let’s talk about how municipal bonds compare to other options, starting with stocks.
Why invest in munis instead of stocks?
Whether you’re considering municipal bonds or corporate bonds, the most basic difference with investing in stocks is that by buying a bond, you’re loaning a public agency or company money in exchange for a pre-agreed rate of interest over the lifetime of the loan. When you purchase shares of a stock, you’re purchasing an equity share in the company. If the company makes money, you stand to profit from its earnings as the value of your shares increases, and potential in the form of dividends too. If the company performs poorly, you won’t see those sought-after dividends. If there’s a bankruptcy, stockholders are behind bondholders in the queue for compensation.
Muni bonds, on the other hand, pay a fixed amount of interest. 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 key phrase in the previous sentence is as long as because if the bondholder defaults, you will not receive your interest payment.
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. We are proud to say that Neighborly is working hard to minimize and make more transparent these markup fees. We believe a more efficient, transparent market benefits all retail investors.
One final point to consider is that stocks have historically been more volatile than bonds. Bonds, on a whole, are considered by most financial experts to be a more stable investment than stocks, and within the bond market itself, munis have notably low default rates. But, as with any investment, it’s important to know the risks and rewards to help find the best investment for your particular situation.
Muni Bonds vs. Mutual Funds
A mutual fund works by investing its investors’ money into a variety of investment vehicles, thus allowing them to diversify. Mutual bond funds — those that focus on bond investments, as opposed to stocks — allow participants to invest in multiple bond issues without having to worry about individual investment minimums. That’s because these funds are able to pool their participants’ resources to purchase bonds.
Since muni bonds generally come with a minimum investment requirement — something that Neighborly is working to change — many investors can easily get priced out of the bonds they’re interested in purchasing.
Mutual bond funds come with minimum investment requirements too, but whereas an individual muni bond is likely to require a $5,000 minimum, you can most likely find a bond fund with a $1,000 minimum.
While some mutual bond funds focus on corporate issues, there are those whose strategies revolve around municipal bonds. And among those, there’s even a subcategory of mutual bond funds that invest primarily in muni bonds issued by specific states.
From a risk-related perspective, most would consider mutual bond funds to be less risky than individual bonds because of their diversified nature. Even if a particular investment loses value or even defaults, a well-managed mutual bond fund will have its assets spread widely enough to more easily absorb this type of loss. With an individual bond, a decline in market value will be more pronounced, and a default is bound to more greatly impact investors.
On the other hand, mutual bond fund returns can suffer when interest rates go up. When interest rates rise on a whole, individual bond prices tend to go down. But if you buy a bond with a decent interest rate and hold it till maturity, you won’t lose out on any money. Cash out a mutual fund investment at a time when interest rates are higher, and you may end up taking a hit.
Though mutual bond funds offer the advantage of diversified holdings and built-in portfolio management, they also tend to come with hefty fees. Those fees, in turn, can eat into your profit, whereas if you’re able to buy a muni bond directly, your profit is yours to keep. Also, for those who prefer a hands-on approach to investing, ceding control to mutual fund managers may not be so appealing. When you purchase individual muni bonds, you get a chance to evaluate their credit risk and decide whether they’re right for you. Just as importantly, you get an opportunity to invest in projects or communities that are important to you.
As far as performance goes, mutual bond funds that focus on munis may offer returns that are similar to those generated by individual issues, only with less perceived risk. Recently, the five-year average return for intermediate-term municipal bond funds has been reported as 4.42%, and some state-specific funds have averaged upward of 4% over the past 10 years. These numbers are comparable to the average return on individual munis, but holders of individual muni bonds can avoid the annual management fees associated with mutual funds.
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. They’re typically far less volatile than stocks, and their average historical return reflects these risk-related tiers. And while stocks may offer better returns, they’re far, far riskier. Munis offer a relatively safe place for investors to put their money, and they come with a world of flexibility. Buying municipal bonds through a mutual fund is one path to get into the municipal market, but if you’d like to avoid fees and fixed your returns rather than fluctuating with the market, individual bonds may be worth considering. In our next post, we’ll explore how to compare investing in municipal bonds versus Treasuries, Corporate Bonds, and Credit Deposits (CDs).
In the meantime, if you’d like to learn explore the local investment opportunities available to you, go to neighborly.com/explore.
This article was updated on November 3, 2017.