When people talk about building a balanced investment portfolio, they’re usually talking about two related ideas: asset allocation and diversification. Municipal bonds can play a role in both—but only if you understand what they are, why they’re used, and what risks come with them.
Asset Allocation and Diversification: The Big Picture
Asset allocation means dividing your portfolio among broad categories—often stocks, bonds, and cash—to manage volatility and risk. One example approach might be 50% stocks, 40% bonds, and 10% cash.
Diversification means spreading your investments within and across those categories. Even inside “bonds,” investors might mix different types—such as government bonds, corporate bonds, and municipal bonds—to avoid depending too heavily on a single segment.
The “right” mix depends largely on your time horizon (how long until you expect to need the money) and your risk tolerance (how much uncertainty and potential loss you can handle).
What Municipal Bonds Are (and Why Investors Consider Them)
Municipal bonds (“munis”) are debt securities issued by government entities—like states, cities, counties, territories, and other public bodies—to fund projects (schools, highways, sewer systems) and ongoing public needs.
A major reason investors look at munis is taxes: interest on many municipal bonds is generally exempt from federal income tax, and it may also be exempt from state and local taxes if you live where the bond is issued (or if it’s issued by a U.S. territory).
Because of these tax benefits, tax-exempt munis often offer lower interest rates than taxable bonds with similar features (like maturity and credit quality).
“Lower Risk” Doesn’t Mean “No Risk”
Bonds have risks, and municipal bonds are no exception. While munis are often viewed as relatively conservative compared with some other bond types, municipal issuers and bonds vary widely, and some bond investments can even involve more risk than stocks in certain scenarios.
A smart approach is to research the specific bond and issuer and understand the risks that matter most for your situation.
Core Risks to Understand Before Buying Munis
1) Credit or default risk
This is the risk the issuer may face financial stress and be unable to pay interest and principal in full. Defaults are generally rare, but they do happen. The bulletin cites major distress examples like Detroit’s bankruptcy filing (2013) and a bankruptcy-like process for Puerto Rico’s debt (2017).
Factors that can raise credit risk include:
- political, legislative, or regulatory changes
- local economic downturns affecting tax revenue and spending needs
- increased pressure from public pension funding
2) Call risk
Many municipal bonds are callable, meaning the issuer can retire the bond before maturity—often when interest rates fall (similar to a homeowner refinancing). If your bond is called, you may receive a pre-set call price that could be more or less favorable than what you paid in the secondary market. If you were planning to hold the bond to maturity, call provisions can disrupt that plan.
3) Inflation risk
Inflation reduces purchasing power. If you’re receiving a fixed interest rate, inflation can erode the real value of those payments. Inflation can also push interest rates higher, which can pressure bond prices.
4) Interest rate risk
Bond prices generally move down when interest rates rise and up when rates fall. If you hold a fixed-rate municipal bond and need to sell before maturity during a period of rising rates, you could lose money because newer bonds may pay higher rates and look more attractive to buyers.
5) Liquidity risk
Some municipal bonds don’t trade frequently. That can make it harder to buy or sell quickly at a predictable price. Quoted prices for the same bond may vary, and recent trade data may not exist for bonds that rarely trade.
A Practical Way to Think About Munis in a Portfolio
Municipal bonds can be a useful tool for some investors—especially when tax considerations matter—but they still require:
- thoughtful asset allocation (how much you hold in bonds overall)
- real diversification (not concentrating in one issuer or a narrow set of similar bonds)
- a clear understanding of credit, call, inflation, interest-rate, and liquidity risks