Municipal Bonds
What is a Municipal Bond?
Municipal bonds, or "Muni bonds", are debt securities issued by states, cities, counties, and other governmental entities to fund a variety of projects such as schools, roads, hospitals, and sewer systems, along with other projects for the public good. When you purchase a municipal bond, you are loaning money to the municipality for a stated period of time during which the borrower will pay you a stated amount of interest. At the end of this set time, you will be repaid your principal investment.
What are the tax advantages of Municipal Bonds?
For a majority of municipal bonds, the interest that you earn is tax-exempt at the federal, state, and local level. This allows the municipality to borrow money at lower interest rates. Because of this feature, the higher your income tax bracket, the greater your benefit becomes by owning this type of investment. When evaluating the placement of municipal bonds in your investment portfolio, you should always compare them with the after-tax return of your taxable investments.
However, not all municipal bonds are exempt from federal taxes. Taxable municipal bonds do exist. Some municipal bonds, generally revenue bonds, are subject to the AMT tax. Most states tax the interest that their residents earn when they own bonds from other states. You should always consult your financial advisor to determine which municipal bond will best fit your needs.
Benefits of MUNicipal Bonds
- A predictable stream of income, which in some cases is tax-free at the federal, state, and local levels.
- A generally high degree of safety with regard to interest payment and principal repayment.
- A wide variety of bonds to choose from for all types of investors. Select bonds by credit quality, choice of issuer, type of bond structure or geographical location.
- Marketability in the event you should choose to sell the bond before it matures.
Risks of Municipal Bonds
Credit Risk Credit risk is reflected in a bond’s rating. This risk is the chance that the issuer will be unable to make debt service payments or will default on the loan because of its weakening credit. As long as you hold the bond to maturity, the bond maintains its interest payments, and repays your principal at maturity, this will have no affect on you. However, should you need to sell your bond into the open market after a downgrade, the market will generally pay you less than what you paid in order to raise the yield for taking on the increased level of risk.
Default Risk If the issuer of the debt is not able to pay back the interest or principal, it will default on the bond. To protect against this, many issuers with lower credit ratings will often have their bond issues insured by a major insurance agency to guarantee the interest and principle.
Interest Rate Risk When you own a bond, interest rates in the open market may rise thus making your rate less attractive to investors. In order to sell your bond, if you choose to not wait until it matures, you will have to offer it at a lower price than you paid in order to make the yield for the purchaser equal to that of a new bond being issued in the current market.
Who Owns Municipal Bonds?
Individual investors and mutual funds own about 71% of municipal bonds. Insurance companies own about 15% and banks own a majority of the remainder at about 10%.
