Key Takeaways
- Municipal bonds, or “munis,” are loans to local governments that often offer tax-exempt interest income.
- Money market funds invest in short-term, high-quality debt and are known for stability and liquidity.
- Both municipal bonds and money market funds can provide stable income but differ in risk levels and tax implications.
- Municipal bonds carry the risk of default and interest rates not keeping up with inflation.
- Money market funds, while safe, typically offer lower returns; consider them for liquid, low-risk savings.
Municipal bonds and money market funds are two popular investment choices for those looking for low-risk options. Municipal bonds, often referred to as “munis,” are debts issued by state or local governments to fund public projects. Money market funds are mutual funds that invest in short-term, high-quality debt securities, offering stability and liquidity. Municipal bonds can be a tax-efficient way to earn income, while money market funds provide reliable, albeit lower, returns.
We’ll explain benefits and risks of municipal bonds and money market funds and how they might fit into your investment portfolio so you can decide which option might be more aligned with your financial goals.
Understanding Municipal Bonds and Their Benefits
Municipal bonds refer to debt that is issued by state or local governments to finance capital expenditures. When you buy a municipal bond, you are loaning money to the municipality, which agrees to pay you back with interest. These governments use the money raised by muni bond issues to fund projects which are then repaid to creditors through revenue generated by that project (e.g. a toll road), or else by taxing its citizens.
Income from these bonds is usually tax-exempt at the federal, state, and local levels, making it attractive to investors seeking to lower their taxable income. As a result, they tend to have lower yields than a taxable equivalent bond. Munis also may have lower yields because these bonds are issued by government entities that can tax their citizens.
These governments, however, cannot print money or issue Treasurys, and are therefore more risky than bonds issued by the federal government. Indeed, municipalities and even states have defaulted on their municipal bond issues in the past.
Exploring Money Market Funds and Their Role
Money market funds are fixed-income mutual funds that invest in high-quality debt securities, usually with very short maturities and low credit risk. Money market mutual funds are among the lowest-volatility types of investments. Income generated by a money market fund is either taxable or tax-exempt, depending on the types of securities the fund invests in.
There are some money market funds that are primarily invested in municipal bonds, thus creating municipal money market funds. These funds bring together the tax benefits of municipal bonds with the stability, liquidity, and diversification qualities of money market funds. All of these benefits tend to attract high-income investors seeking a tax shelter.
Risks of Investing in Municipal Bonds
One of the major risks associated with municipal bonds is the possibility that short-term yields will rise. This means other bonds coming on the market will pay a higher rate to bond owners, and your bond will be seen as less valuable. This can cause the price of your bond to drop. This is only a problem if you decide to sell the bond. You will still receive your interest payments.
Another risk is that municipal bond returns may not keep pace with inflation. If inflation rises, your bond yield will stay the same. Eventually, you may be making less in interest than the inflation rate. If inflation is at 5% and you are earning 3%, you are losing money. Your interest income won’t have as much buying power. Though extremely rare, default is also a risk to investors in municipal bonds.
Evaluating Money Market Fund Risks
This is one of the safest investments you can find. These funds very rarely lose value, and the interest they pay is reliable. Because of this safety, they also pay very low interest. Risk and reward are always related: Lower risk means lower reward.
How Do You Invest in Municipal Bonds?
You can easily buy municipal bonds through an online brokerage, such as Fidelity. These platforms will typically offer a list of available municipal bonds, along with information about the issuer and their credit rating. If you want to avoid the hassle of researching individual bonds, there are also mutual funds and ETFs that invest in a wide basket of municipal debt.
Are Municipal Bonds Tax Free?
Municipal bonds are generally not taxed at the federal level, but there are caveats. It may depend on what the bond is being used for—some government activities are not tax-exempt, so a bond to fund those activities would be subject to federal income taxes. In addition, income from an out-of-state bond may be subject to your state’s income taxes.
Are Money Market Funds Safe?
Money market funds are considered to be among the safest short-term investments because they are highly liquid and insulated from market volatility. The downside is that these funds usually have much lower returns than the stock market.
The Bottom Line
If you are investing for income, either municipal bonds or money market funds will pay you interest. Just know that bonds can lose value and money market funds most likely won’t. Note also that since municipal bonds are income-tax free, you are actually making more than the interest rate would indicate. You can factor in your tax savings as part of the value of buying such a bond.
Correction—April 16, 2023. This article has been edited to clarify that money market funds can invest in a variety of debt securities, not just Treasurys.