An Investor’s Guide To Municipal Bonds

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Municipal bonds are often part of a savvy investor’s portfolio. Because of their relatively high credit quality and predictable income stream, they are primarily used to preserve rather than to grow wealth. They are also often used to take advantage of important tax benefits.

What Is A Municipal Bond?

A municipal bond is a debt obligation of a government or public entity. Government or public entities include cities, school districts, counties, states, public universities, community colleges and public utilities. When you buy a municipal bond, the issuer agrees to pay you a set number of interest payments for a predetermined amount of time. When the bond matures, the issuer returns the full amount of your original investment to you. Your profit is whatever interest you accrued above your original investment. The maturity on a municipal bond can range from a few weeks to thirty years.

Traditionally, the interest you receive on a municipal bond is based on a fixed rate. However, more and more municipal entities have begun issuing variable rate bonds which have fluctuating interest rates. Make sure you know whether the interest rate is fixed or variable before you purchase a bond.

Like other types of bonds, municipal bonds are typically rated by the three major national rating agencies. Because of their relatively high credit quality, municipal bonds are typically given investment grade ratings. However, there are lower rated municipal issuers. Use extreme caution when purchasing a non-investment grade municipal bond as there is a higher risk of default.

Types Of Municipal Bonds

Broadly speaking, there are two main types of municipals bonds. These are general obligation bonds and revenue bonds.

  • General Obligation Bonds: General obligation bonds are municipal bonds that are supported by the general obligation pledge of the bond issuer. A general obligation pledge means that the issuer of the bonds is required to do everything in its power, including raising new taxes, to make sure that interest payments on its bonds are paid on time and in full. This represents the strongest type of security for municipal bonds.
  • Revenue Bonds: Revenue bonds are paid by dedicated streams of revenue. For example, the interest on a sewer system revenue bond is paid by revenues generated by a sewer system. It cannot be paid from any other source of revenue. If something happens that prevents the normal functioning of the sewer system, the issuer might be unable to make an interest payment on the bonds. Because revenue bonds have more restricted revenue streams than general obligation bonds, they are generally viewed to be risker and therefore usually pay a higher rate of interest.

What Are The Benefits of Investing In Muni Bonds?

  • Lower Risk Of Default: Municipal bonds are generally viewed as having higher credit quality than other types of debt. This is because municipal bond issuers have a wide variety of methods at their disposal to pay their bonds. For example, a state government has the power to raise taxes in order to pay its bondholders. As a result, there have been very few defaults by municipal bond issuers. In fact, there have been less than 60 municipal defaults since 1970. This low risk of default is a positive feature for investors who are relatively risk averse. However, you should keep in mind that there is always default risk with any bond that you purchase. Therefore, you should closely follow the financial health of the issuer of any bonds that you purchase.
  • Tax Exemption: Most, although not all, municipal bonds are exempt from federal income taxes. Many are also exempt from state and local taxes as well. This tax exemption offers a benefit to investors because it prevents the government from taxing the interest that you earn on the bonds. Keep in mind that if you are subject to the alternative minimum tax, you might have to pay taxes on some of your municipal bonds. If you are subject to the alternative minimum tax and want to invest in municipal bonds, you should consult with your tax advisor to find out which municipal bonds to avoid.
  • Predictable Income Stream: The combination of high credit quality with regular interest payments means that municipal bonds offer a steady stream of investment income. This contrasts with stocks and other more volatile investments which often experience significant swings in value. Be aware that some municipal bonds offer variable rates of interest. This means that your interest payments will vary depending on the movement of variable rate indices.

What Are The Drawbacks Of Investing In Muni Bonds?

  • Lower Returns: Because they are less likely to default than corporate bonds, municipal bonds generally pay lower interest rates. Additionally, because of the tax benefit, their interest rates are generally lower than those of taxable bonds. If your goal is to grow your wealth, you might want to invest in assets that offer a higher rate of return.
  • Limited And Out Of Date Financial Information: Municipal issuers are notorious for their financial reporting. Unlike corporations that release detailed financial information on a quarterly basis, most municipal issues are only required to report yearly financial statements. Additionally, many issuers do not publish their annual financial reports on time. In some cases, it can take a year for them to report their finances for the previous year. This makes it hard for the investor to keep up to speed on the financial health of municipal issuers.
  • Call Features: Some municipal bonds have call features. This means that the bond issuer can repay a portion or the full amount of the bond prior to the maturity date. In effect, this means that you will not receive all of the interest payments that you would have had you held the bond to maturity. You usually receive a premium if the bond is called early. However, this premium might not equate to the missed interest payments.

If you are looking for a relatively safe way to invest your money, municipal bonds offer a great way for you to earn income and while earning a tax benefit.

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Last Updated: February 3, 2012
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About Michael Diaz Michael Diaz is a contributing author for CanDoFinance.com.

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