Investors seek out government bonds because they tend to be low-risk and stable investments.

The primary difference between municipal bonds, also known as "munis," and money market funds is that municipal bonds are single bond issues from local or state governments, while money market funds are a type of mutual fund that invests in very-short term Treasuries issued by the federal government.

Key Takeaways

  • Governments issue debt in the form of bonds in order to raise funds for projects and expenditures.
  • The federal government issues Treasuries, where money market funds invest in very short-duration Treasuries that are essentially risk-free but carry very low yields.
  • Municipal bonds are issued by state or local governments and carry a higher degree of risk, but they can also be income-tax exempt making them attractive to certain investors.

Municipal Bonds

Municipal bonds refer to debt that is issued by state or local governments to finance capital expenditures. When you buy a municipal bond, you are loaning money to the municipality, which agrees to pay you back with interest. These governments use the money raised by muni bond issues to fund projects which are then repaid to creditors through revenue generated by that project (e.g. a toll road), or else by taxing its citizens.

Income from these bonds is usually tax-exempt at the federal, state and local levels, making it attractive to investors seeking to lower their taxable income. As a result, they tend to have lower yields than a taxable equivalent bond. Munis also may have lower yields because these bonds are issued by government entities that can tax their citizens. These governments, however, cannot print money or issue Treasuries like the federal government, and are therefore more risky than bonds issued by the federal government. Indeed, municipalities and even states have defaulted on their municipal bond issues in the past.

Money Market Funds

Money market funds are fixed income mutual funds that invest in high-quality federal government debt securities, usually with very short maturities and low credit risk. Money market mutual funds are among the lowest-volatility types of investments. Income generated by a money market fund is either taxable or tax-exempt, depending on the types of securities the fund invests in. 

There are some money market funds that are primarily invested in municipal bonds, thus creating municipal money market funds. These funds bring together the tax benefits of municipal bonds with the stability, liquidity and diversification qualities of money market funds. All of these benefits tend to attract high-income investors seeking a tax shelter

Their Risks

Municipal Bonds

One of the major risks associated with municipal bonds is the possibility that short-term yields will rise. This means other bonds coming on the market will pay a higher rate to bond owners, and your bond will be seen as less valuable. This can cause the price of your bond to drop. This is only a problem if you decide to sell the bond. You will still receive your interest payments.

Another risk is that municipal bond returns may not keep pace with inflation. If inflation rises, your bond yield will stay the same. Eventually, you may be making less in interest than the inflation rate. If inflation is at 5% and you are earning 3%, you are losing money. Your interest income won't have as much buying power. Though extremely rare, default is also a risk to investors in municipal bonds.

Money Market Funds

This is one of the safest investments you can find. These funds very rarely lose value, and the interest they pay is reliable. Because of this safety, they also pay very low interest. Risk and reward are always related: Lower risk means lower reward. 

The Bottom Line

If you are investing for income, either municipal bonds or money market funds will pay you interest. Just know that bonds can lose value and money market funds most likely won't. Note also that since municipal bonds are income-tax free, you are actually making more than the interest rate would indicate. You can factor in your tax savings as part of the value of buying such a bond.