Muni Bonds vs. Bond Funds: Better Together?

A lot of people say that death and taxes are the only guarantees in life, but you can certainly add change to that list. And when it comes to investing, too many people tend to look at a situation as black or white. As is the case with most things in life, in order to be successful, it’s important to have maneuverability. 

Investing in bonds adds a bit of stability to one's investment portfolio, especially during bear markets when stocks are volatile and their returns are depreciating. But if you invest only in an individual municipal bond — a debt security issued by a state, city or county — with a set-it-and-forget-it approach, then you would be lacking diversification and putting your money at risk. Despite municipal bonds having a very low default rate on a historical basis, even the highest-rated municipal bond has the potential to default. (For related reading, see: Diversify With Municipal Bond ETFs.)  

A potentially smarter solution to investing in munis is to spread your capital out across various individual municipal bonds. This requires a great deal of research and tracking of your investments, which means a lot of invested time in addition to lots of capital. Another option is to complement investments in municipal bonds with investments in bond funds — funds invested primarily in bonds and other debt instruments — which spreads your risk out a bit while allowing you to keep a steady income stream. (For more, see: How Does Duration Impact Bond Funds?)

Let’s dig a little deeper.

Municipal bonds are attractive because of their safety. Income investors like municipal bonds for their safety, but also for the specific payout amounts on a bi-annual basis. The investor’s principal will also be returned when the bond matures. (For related reading, see: How Is a Corporate Bond Taxed?) 

The biggest risk with municipal bonds is default, but you can limit this risk by checking the municipal bond’s credit worthiness. Also, if you see a high yield on a municipal bond, it means higher risk. An added tip is that general obligation bonds are safer than revenue bonds because an issuer is relying on taxes to pay the bond holder, and taxes can always be raised. With revenue bonds, the issuer is relying on the performance toll road, airport, hospital, etc. (For related reading, see: How Are Zero-Coupon Municipal Bonds Taxed?)

If you’re willing to invest more time and money, you can diversify your portfolio of individual municipal bonds to manage interest rate risk. You can also sell an individual municipal bond before it matures, but this could lead to a profit or a loss. This will depend on the price you paid for the bond, the interest you’ve collected, current interest rates, and the current price of the bond. A negative here is that individual municipal bonds aren’t very liquid.

Investing in just one individual municipal bond would present high risk. Therefore, a lot of time and capital would be required to spread out your risk across a variety of individual municipal bonds. If you want to allocate a lot of capital in one place while mitigating your risk and not having to do a lot of research, then your first considerations should be treasury bonds. (For related reading, see: Is a Treasury Bond a Good Investment for Retirement?) 

The biggest advantage of investing in bond funds is diversification. A bond fund, or bond mutual fund, acts similar to a stock mutual fund, where diversification is the primary focus. Risk is spread out across many different types of investments and the fund is managed by a professional. Instead of diversifying across sectors and industries — or across small-caps, mid-caps, and large-caps like a stock mutual fund — a bond mutual fund diversifies across short-term bonds, medium-term bonds, long-term bonds, U.S. government agencies, corporations, and more. (For more, see: Bond Basics: Introduction.)

You can also find focused bond mutual funds, which is set up similarly to a focused stock mutual fund. For example, in a focused stock mutual fund, the focus might be on small caps spread across different sectors and industries. In the case of a focused bond mutual fund, the focus might be on short-term treasuries, investment-grade bonds or junk bonds. (For more, see: Pros and Cons of Bond Funds vs. Bond ETFs.)

Bond funds, in general, pay monthly, but not on the same day every month. The monthly payments are possible because of the mix of distribution dates for the bonds within the fund. This is also why the distribution date changes.

If you sell a bond mutual fund, you will receive the NAV minus a redemption fee (in some cases). Bond funds rarely hold bonds to maturity, which makes them more liquid. You can also invest in a bond fund ETF. If you take this approach, consider Vanguard since it has very low fees. (For related reading, see: Vanguard to Launch Muni Bond ETF.)

When you invest in a bond mutual fund, check the annual expense ratio and if there’s a transaction fee with the purchase. Do some comparison shopping to make sure you’re getting the best deal. (For more, see: Bond Basics: Yield, Price and Other Confusion.)

Default risk is much lower when you invest in a bond mutual fund, simply because the risk is spread out. If one bond defaults, it’s not going to have a disastrous impact on your portfolio. If you’re the type of investor who wants a steady income stream without having to stay on top of your investments, then you might want to be more heavily weighted toward bond funds than individual municipal bonds. However, savvy investors will often mix in a little of both, along with stocks, CDs, real estate, and possibly currencies and commodities, depending on current market conditions.

You manage individual municipal bonds. That being the case, if you limit your investments to one or just a few, you face higher risk. If you want diversification, then more time and capital will be required. Individual municipal bonds have historically offered very low risk and reliable interest payments, which are usually bi-annual (not to mention a tax advantage). For the lowest risk, consider general obligation bonds opposed to revenue bonds. However, both types of individual municipal bonds lack liquidity. Adding bond funds or bond mutual funds to your portfolio offers diversification, which limits default risk. Bond funds are more liquid and payments are usually monthly. They are a better option for investors who don’t have as much time or money available. That said, individual municipal bonds and bond funds can complement each other well. (For more, see: Muni Bonds vs. Taxable Bonds and CDs.)