Investing in municipal bonds

Like bonds issued by the federal government or corporations, municipal bonds are simply debt instruments—money lent by investors to states, counties, cities, and nonprofit organizations to pay for public projects or to refinance existing debt. In return for an investor’s loan, the municipality promises to pay the investor interest—usually semiannually—and to return the investor’s principal on a specified date, often referred to as the maturity date (assuming no default).

In general, municipal bonds fall into one of two categories—general obligation or revenue bonds. This categorization is based on the source of their interest payments and principal repayments. However, within these categories, a municipal bond can be structured in different ways, with each variation offering different benefits, risks, and tax treatments.

Municipal bonds have a wide range of credit quality (a measure of the municipality’s financial health and ability to repay the bond), maturities, and yields. These bonds help finance a variety of projects like schools, hospitals, roads, bridges, housing, utilities and more.

Over time, investing in municipal bonds has become more complex, as the municipal bond market is large and fragmented. Today, less than 10% of newly issued bonds are insured. Focusing only on yield could lead to increased volatility and risk. Few investors have the resources to find municipal bonds that align with their goals and risk tolerance.

Advantages and tax considerations for municipal bond investors

Municipal bonds provide the potential to earn attractive amounts of after-tax income. Municipal tax-exempt bonds typically have coupons of 3% to 5% that pay out interest to bondholders on a semiannual basis. This interest is exempt from federal income tax, and if issued by an in-state issuer, is often exempt from state income tax.

In addition to coupon income, tax-exempt bond prices move in response to changes in market rates and credit spreads. This creates the potential for positive total returns from capital gains in addition to the tax-exempt income from the coupon. Tax-exempt bonds are the only way to get investment exposure to municipal issuers and are often in short supply relative to investor demand.

Outside of tax considerations, municipal bonds historically have had low correlation to other asset classes, such as stocks. Adding a municipal bond fund to your portfolio can be an effective diversifier. While diversification can’t prevent a loss, it may temper volatility.

How Fidelity can help you navigate the municipal bond market

Since offering its first tax-exempt mutual funds in 1977, Fidelity remains committed to offering strong tax-exempt risk-adjusted returns to its clients. Fidelity has a broad array of municipal bond mutual funds—from short national funds with the least interest rate sensitivity, to long national funds with more interest rate sensitivity.

Fidelity’s approach to managing municipal bond funds places a premium on income and capital preservation. Rather than pursuing the highest yield, which can add volatility, our managers look at a bond’s total return potential to generate both income and price appreciation while keeping a tight focus on risk.