Investing in municipal bonds is a good way to preserve capital while generating gradual interest. They also have tax free benefits. Another way to look at investing in municipal bonds, often called munis, is that you will be helping build infrastructure in your local area. (For more, see: The Basics of Municipal Bonds.)

Types of Municipal Bonds

There are two types of muni bonds. General obligation bonds generate money via taxes. This is the safest type but often have the lowest interest rates.

Revenue bonds generate money via ticket sales, bills, tolls, rent, etc. These are used to help build infrastructure.

Municipal Bonds vs. Corporate Bonds

Municipal bonds present several advantages over corporate bonds. While the interest on a corporate bond is likely to be higher, it’s not tax exempt. Most municipal bonds are exempt from federal taxes. If you’re investing in a local municipal bond (state, county, or city), it will also be exempt from local taxes but check your local tax laws for confirmation. If you invest in a municipal bond in another state, county or city you will likely have to pay taxes. Assuming you invest in a completely tax-free municipal bond, the interest rate will be lower than a corporate bond, but when you factor in the tax impact (or non-impact), a municipal bond will almost always present a more profitable opportunity. (For more, see: Avoid Tricky Tax Issues on Municipal Bonds.)

Another advantage over corporate bonds is that municipal bonds have a much lower rate of default. In 2014, the municipal bond default rate was just 0.10%, an improvement over the 0.11% default rate in 2013. The corporate bond default rate usually ranges between 1.5% and 3.0%.

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Should You Consider Muni Bonds?

Other Benefits

Finance gurus Warren Buffett and Meredith Whitney predicted catastrophe in the municipal bond market, but those predictions never came to fruition, at least not yet. Since then, the majority of municipalities in the United States have improved their fiscal houses. However, this doesn’t mean the risk has been eliminated. (For more, see: What's Going on with Muni Bonds?)

Municipal bonds are also liquid. They can be purchased on the primary market at the time of issuance, or they can be purchased from a bond holder on the secondary market.

Muni Bond ETFs

In most cases, if you invest in a specific-purpose municipal bond, then it’s likely to be alternative minimum tax (AMT) free. There are also municipal bond exchange traded funds (ETFs) that are AMT free such as the iShares National AMT Free Muni Bond (MUB) and the Market Vectors Short Municipal ETF (SMB). Over the past three years, these ETFs have appreciated 9.79% and 3.55%, respectively. (For more, see: Top 2014 Muni Bond ETFs.)

Municipal bond ETFs also offer a lot of diversification. With exposure to so many municipal bonds even if one were to default, it wouldn’t have a major impact on the ETF. Most municipal bond ETFs keep their portfolios well balanced, with one municipal bond’s percentage of net assets usually not exceeding 2%. The biggest negative for municipal bonds ETFs is that it’s still possible to suffer significant losses. This is unlike an individual bond, where all your money will be returned to you at maturity with interest.

The Bottom Line

Municipal bonds aren’t bulletproof, but they’re one of the safest investment vehicles you will find. That safety will likely lead to small returns, but those returns will be tax free. (For more, see: The Stealth Wealth in Municipal Bonds.)

Dan Moskowitz does not have any positions in MUB or SMB.