Investing in bonds adds stability to investment portfolios, especially during bear markets when stocks are losing money. If you only buy an individual municipal bond, the lack of diversification creates unnecessary risks. Despite municipal bonds having a very low historical default rate, even the highest-rated municipal bond has the potential to default. For long-term bonds, diversification becomes more valuable because default risk is inherently higher.

KEY TAKEAWAYS

  • If you only buy an individual municipal bond, the lack of diversification creates unnecessary risks.
  • The most significant advantage of investing in bond funds is the reduction in default risk.
  • There are many muni bond funds, so you can diversify without giving up the tax advantages of municipal bonds.
  • In the long term, bond funds are usually a better option than individual muni bonds.

A better solution may be to spread your funds out across various individual municipal bonds. This requires a great deal of research and a significant amount of capital. Another option is to complement investments in municipal bonds with investments in bond funds, which spreads your risk out while allowing you to maintain a steady stream of income.

Default Risk

The greatest risk with municipal bonds is default, but you can limit this risk by checking the municipal bond’s creditworthiness. Also, if you see a high yield on a municipal bond, it means higher risk. An added tip is that general obligation bonds are safer than revenue bonds. With general obligation bonds, an issuer is relying on taxes to pay the bondholder, and taxes can always be raised. With revenue bonds, the issuer is relying on the performance of toll roads, airports, hospitals, and other specific improvements.

For the lowest risk, choose general obligation bonds instead of revenue bonds.

The most significant advantage of investing in bond funds is the reduction in default risk. A bond fund is similar to a stock fund. Instead of diversifying across sectors and industries, a bond market mutual fund diversifies across short-term bonds, medium-term bonds, long-term bonds, government bonds, and corporate bonds. You can also invest in a bond fund ETF. There are many muni bond funds, so you can diversify without giving up the tax advantages of municipal bonds. Default risk is much lower when you invest in a bond mutual fund because the risk is spread out.

Short Term vs. Long Term

Individual short-term municipal bonds are usually sound investments. In the short term, an investor can just look at the credit rating of a particular municipal bond to determine its risk. If a municipal bond with a maturity of less than five years is investment grade, then it is very likely to repay the principal. What is more, investors are less likely to need the money for other purposes in the short run. Therefore, it should be possible to buy a short-term muni bond, collect the interest, get back the principal, and ignore price fluctuations.

In the long term, bond funds are usually a better option than individual muni bonds. Over several decades, even prosperous municipalities can experience difficult times and distressed credit ratings. An investor today cannot foresee which individual municipal bonds will fare best. Even worse, a longer duration makes bond prices more volatile and more vulnerable to credit quality issues. It is also less realistic to expect to hold a muni bond for 20 or 30 years. Bond funds help to reduce default risk and increase liquidity, both of which may be more important in the long run.

The Bottom Line

If you limit your investments to just a few muni bonds, you face increased risk without compensation. However, municipal bonds have historically offered very low risk, reliable interest payments, and tax advantages. For the lowest risk, choose general obligation bonds instead of revenue bonds. However, both types of individual municipal bonds lack liquidity. Adding bond ETFs or bond mutual funds to your portfolio adds diversification, which limits default risk. Bond funds are also more liquid, and their advantages are even stronger in the long run. Finally, remember that municipal bond funds often offer the same tax savings as individual muni bonds.