Advantages & Disadvantages of Tax-Exempt Bonds

Tax-exempt bonds, commonly called municipal bonds, offer many advantages to investors. States, cities and counties offer municipal bonds to investors to raise money for infrastructure needs, daily operations and other projects. Although municipal bonds offer many benefits, they also offer some disadvantages and risks. As an investor, you should understand the benefits and limitations of investing in municipal bonds to decide if they fit within your present or future financial situation.

Keep More of Your Earnings

The main advantage of investing in municipal bonds is the ability to keep more of your returns because of tax exemption. When you buy a bond that is not exempt, you must pay taxes on your interest income. So, even though you may earn an 8 percent rate of return on your corporate bond, in actuality you earn less than that because of taxes. A municipal bond allows you to avoid paying taxes on your interest income. In some cases, even though the rate of return of a municipal bond is lower than the rate of return on a corporate bond, you can still earn more money in interest investing in the municipal bond because of the money you saved through tax exemption.

Low Price Volatility

Tax-exempt bonds experience low price volatility, which makes them a great investment for the purpose of diversification. Although not completely risk free, municipal bonds are relatively low-risk assets. Much of the low risk and price volatility of the bonds is derived from the municipalities’ credit ratings. The low risk and price volatility features are especially attractive to senior investors looking for safe investment to protect their retirement income. However, investors should research municipal bonds before making investment decisions.

Economic Risk

Many state and local communities suffer during times of recession, so it is important to analyze the economic conditions of states and localities issuing bonds to find out if the bonds meet your investment needs. Economic risk is a disadvantage of investing in municipal bonds. Investors should research the agency’s track record and know how the municipality earns its revenue. The spending history of a state or local government can tell investors a great deal about the region's economic stability. To get a good sense of an issuer’s financial position, you can check the credit rating of municipal bonds with credit rating agencies.

Interest Rate Risks and Returns

Compared to other bond types, municipal bonds offer relatively low returns. The low returns of municipal bonds come from the fact that they are relatively short-term, low-risk investments. Municipal bonds are also subject to interest rate risk, meaning that as interest rates rise, the market price of municipal bonds fall. The longer the term of your municipal, the more exposed you are to interest rate risk. Like other bonds, a municipality may call back a municipal bond if interest rates continually decline. In the mind of the municipality, it prefers to call back the bond and reissue it at a lower rate to avoid paying you a higher rate of return