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Related Articles. Investing The Basics of Municipal Bonds. Partner Links. Changing interest rates may have a significant effect on fixed-income investments. New Administration, New Tailwinds for the Muni Market Several Biden Administration proposals could make muni bonds more attractive for a variety of investors. Municipal bond defaults are infrequent.
Municipal bonds tend to move independently of equity markets. Because they are domestically focused, muni bonds generally lack exposure to some of the same concerns and sources of volatility that global equities face.
So when equity markets gyrate, muni bonds can serve as an important diversification complement within your portfolio. Because municipal bonds seek to provide tax-free income, they have generally offered higher tax-equivalent yields than their taxable counterparts. For example, as of February 28, , muni bonds were yielding 1.
But after considering the impact of taxes, the taxable-equivalent yield the return required on a taxable bond to make it equal to the return of a tax-exempt bond of municipal bonds was more attractive, 2. In addition, the government has taken steps that could support the muni market. In , they put their rate increases on hold and cut rates as economic conditions shifted, and cut them to near zero in in response to the COVID pandemic.
Although there can be short-term volatility when rates move unexpectedly, FIGURE 2 shows that muni-bond performance has historically been interest-rate agnostic: On average, muni bonds have posted positive returns whether interest rates were rising, stable, or declining.
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ETFs and mutual funds are considered a single population. The Overall Rating is derived from a weighted average of the performance figures associated with its 3-, 5-, and year if applicable Morningstar Rating metrics.
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Overall, 5 stars, 3-Year, 4 stars, 5-Year, 4 stars, and Year, 5 stars, rated against , , and products, respectively. Muni bonds carry "interest rate risk " as well. If interest rates go up while you still own a particular muni bond, you will earn a lower yield than you'd be able to attain from a new issue in the future. Interest rate changes will affect the value of your bonds on the secondary market, too. If you have to sell a bond in the future, you may have to sell it below redemption value to compensate for the lower yield if rates go up.
There are three major ratings agencies that rank bond issuers based on their likelihood of meeting their financial obligations versus defaulting on them. Generally, the higher an issuer's credit rating, the lower the interest rate its bonds pay. Conversely, issuers with a lower rating generally must offer higher interest rates to offset their associated risk. But remember that bond ratings can change. Just because an issuer starts out with a strong rating doesn't mean it can't get downgraded if its financial circumstances change.
Muni bonds have a high rate of recovery even when they default, but your capital can be tied up longer than the term of the bond, and investors rarely recoup interest not paid.
So be sure to consider all the implications when considering which municipal bonds to buy. Municipal bonds differ from corporate bonds in the tax treatment of the interest they pay, and they also have lower default rates. This is why municipal bonds generally pay lower yields than similar corporate bonds. In short, the risk-reward profile for munis and corporate bonds is different. If less risk is your priority, munis come out ahead; if better yields with higher risk suits you, corporate bonds get the nod.
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