You can buy municipal bonds directly from a broker, through a mutual fund, or from your bank — each route has different costs and minimum investments

Municipal bonds are sold through brokerage accounts, not directly from municipalities. You open an account with a broker (a firm licensed to buy and sell securities), fund it with cash, and then place an order for the specific bonds you want. The broker charges you a commission or markup on the purchase, though some brokers waive commissions on municipal bonds to attract customers. You can also buy municipal bond mutual funds or exchange-traded funds (ETFs) instead, which bundle many bonds together and charge an annual fee.

The three main routes differ in cost, control, and the amount of money you need to start. Direct purchase through a broker gives you the most control but requires more research and usually a minimum investment of $5,000 per bond. Mutual funds and ETFs let you start with smaller amounts and spread your money across many bonds automatically, but you pay annual management fees and have less say in which bonds you own. Banks sometimes sell municipal bonds to their customers, though their selection is usually limited and their markups can be higher than brokers.

Key Takeaways

  • You need a brokerage account to buy municipal bonds; you cannot purchase them directly from a city or county government.
  • Individual bond purchases typically require a minimum of $5,000 per bond and let you hold the bond until maturity, but you must research each bond yourself.
  • Municipal bond mutual funds and ETFs let you start with smaller amounts and own pieces of many bonds, but you pay annual fees and cannot choose individual bonds.
  • The tax-free interest income from municipal bonds is most valuable if you are in a higher tax bracket and live in the state that issued the bond.
  • You should compare the after-tax yield of a municipal bond to a taxable bond before deciding which is the better investment for your situation.

Opening a brokerage account and choosing a broker

Start by opening an account with a brokerage firm. Major brokers that offer municipal bonds include Fidelity, Charles Schwab, E*TRADE, TD Ameritrade, and Vanguard. Each broker has a website where you can open an account online in 15 to 30 minutes by providing your name, address, Social Security number, and employment information. You will need to link a bank account to fund your brokerage account with cash.

When comparing brokers, look at whether they charge a commission on municipal bond purchases (many now waive this fee), what their minimum investment is per bond, and whether they offer municipal bond mutual funds or ETFs if you want that option too. Some brokers have a larger inventory of bonds available for purchase, which matters if you want to choose from many options. Call the broker's customer service line or check their website to ask about municipal bond commissions and minimums before you open an account.

Buying individual municipal bonds through your broker

Once your account is funded, log into your broker's website and search for municipal bonds. You will see a list of available bonds with information like the issuer (the city or county), the interest rate, the maturity date, and the current price. The price of a bond changes based on interest rates and the bond's credit quality, so a bond issued at $1,000 might be selling for $950 or $1,050 depending on market conditions.

Before you buy, check the bond's rating from a credit rating agency like Moody's or Standard & Poor's. A higher rating means the issuer is less likely to default, but higher-rated bonds pay lower interest rates. You should also look at the bond's yield to maturity, which tells you the total return you will earn if you hold the bond until it matures. Compare this to the yield on a taxable bond of similar quality to decide whether the tax-free income is worth it for your situation.

When you are ready to buy, place an order through your broker's platform. You will specify how many bonds you want (usually in increments of $1,000 face value, with a $5,000 minimum) and whether you want to buy at the asking price or place a bid for a lower price. The broker will execute the trade and the bonds will appear in your account. You will receive interest payments twice a year, and when the bond matures, the issuer will return your principal.

Using municipal bond mutual funds and ETFs

A municipal bond mutual fund pools money from many investors and uses it to buy a portfolio of bonds. A fund manager decides which bonds to buy and sell, and you own a share of the entire portfolio. ETFs work the same way but trade on an exchange like a stock, so you can buy and sell them during market hours at a price that changes throughout the day.

The main advantage of funds and ETFs is that you can start with a small amount of money — often $100 to $1,000 — and instantly own pieces of dozens or hundreds of bonds. You do not have to research individual bonds or worry about one issuer defaulting, because your money is spread across many issuers. The downside is that you pay an annual expense ratio (a percentage of your investment that goes to the fund manager), which typically ranges from 0.2% to 1% per year depending on the fund. You also cannot hold a specific bond until maturity; instead, you own the fund for as long as you want and the fund manager buys and sells bonds constantly.

To buy a municipal bond fund or ETF, search for it in your brokerage account the same way you would search for a stock. Look at the fund's expense ratio, its average maturity, and whether it focuses on a specific state (state-specific funds are useful if you live in a high-tax state and want to avoid state income tax on the interest). Place an order and the fund will appear in your account. You will receive distributions of interest income, usually quarterly or monthly.

Understanding the tax benefits and calculating after-tax yield

The main reason to buy municipal bonds is that the interest income is not subject to federal income tax. If you buy a bond issued by your home state, the interest is usually not subject to state income tax either. This tax-free income is most valuable if you are in a high federal tax bracket (28% or higher) or live in a state with high income tax like California, New York, or Massachusetts.

To decide whether a municipal bond is a better investment than a taxable bond, calculate the after-tax yield of the taxable bond and compare it to the municipal bond's yield. If a taxable bond pays 4% and you are in the 24% federal tax bracket, your after-tax yield is 3.04% (4% minus 24% of 4%). If a municipal bond pays 3.2%, it is the better choice because 3.2% is higher than 3.04%. You can find online calculators that do this math for you, or ask your broker to help you compare.

Remember that the tax-free status applies only to interest income, not to capital gains. If you buy a bond for $950 and it rises to $1,000, that $50 gain is subject to capital gains tax when you sell. If you hold the bond until maturity, you will not owe tax on the gain because you will receive the full face value of $1,000.

Evaluating credit quality and default risk

Before you buy a municipal bond, check its credit rating. The three major rating agencies — Moody's, Standard & Poor's, and Fitch — assign ratings based on the issuer's financial health and ability to pay interest and principal on time. Ratings range from AAA (highest quality) down to C or D (highest risk). A bond rated BBB or higher is considered investment grade, meaning it has a low risk of default.

Higher-rated bonds pay lower interest rates because they are safer. A AAA-rated bond might pay 2.5%, while a BBB-rated bond might pay 3.5%. You have to decide whether the extra 1% of interest is worth the higher risk. For most individual investors, sticking with investment-grade bonds (BBB or higher) is a reasonable approach. You can find a bond's rating on your broker's website or on the rating agencies' websites.

You should also research the issuer itself. Look at the municipality's financial statements, its debt levels, and whether it has a history of paying its bonds on time. Many municipalities publish this information on their websites or on the Municipal Securities Rulemaking Board's website (MSRB.org). If you are buying through a mutual fund or ETF, the fund manager does this research for you.

Holding bonds to maturity versus selling early

When you buy an individual municipal bond, you have two choices: hold it until the maturity date and receive your full principal back, or sell it before maturity on the secondary market. If you hold to maturity, you know exactly how much money you will receive and when. If you sell early, the price you receive depends on interest rates and the bond's credit quality at the time of sale.

If interest rates rise after you buy a bond, the bond's price falls because new bonds are paying higher rates. If you need to sell before maturity, you will have to accept a lower price. The opposite is true if interest rates fall — your bond becomes more valuable and you can sell it for more than you paid. This is why bonds are riskier if you might need the money before maturity.

Most individual investors buy municipal bonds intending to hold them to maturity, which eliminates the risk of having to sell at a loss. If you think you might need the money sooner, a municipal bond mutual fund or ETF is a better choice because you can sell your shares at any time without worrying about the bond's maturity date.

Frequently Asked Questions

What is the minimum amount of money I need to start buying municipal bonds?

If you buy individual bonds through a broker, the minimum is usually $5,000 per bond (five bonds at $1,000 face value each). If you buy a municipal bond mutual fund or ETF, you can start with as little as $100 to $1,000 depending on the fund. Some brokers have lower minimums, so check with your broker before opening an account.

Do I have to pay taxes on the interest from municipal bonds?

No, the interest from municipal bonds is not subject to federal income tax. If you buy a bond issued by your home state, the interest is usually not subject to state income tax either. However, if you sell a bond before maturity and make a profit, that capital gain is subject to federal and state income tax.

Can I lose money on a municipal bond?

If you hold a bond to maturity, you will receive your full principal back unless the issuer defaults, which is rare. If you sell before maturity, you could receive less than you paid if interest rates have risen or the issuer's credit quality has declined. Municipal bond mutual funds and ETFs can also fluctuate in value, though the risk is spread across many bonds.

Should I buy individual bonds or a mutual fund?

Individual bonds are better if you want to hold a specific bond to maturity and avoid paying annual management fees. Mutual funds and ETFs are better if you want to start with a small amount, own many bonds automatically, or might need to sell before a specific maturity date. Consider your investment timeline and how much research you are willing to do.

How do I know if a municipal bond is a good investment?

Compare the municipal bond's after-tax yield to a taxable bond's after-tax yield. Check the bond's credit rating and research the issuer's financial health. Make sure the maturity date matches your investment timeline. If you are unsure, a diversified municipal bond mutual fund or ETF removes the need to evaluate individual bonds yourself.