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Municipal bonds, also known as “munis,” have appealing aspects that make for a compelling investment opportunity. These bonds provide investors with steady interest payments, boast relatively low risk, and have the advantage of being tax free at the federal level and potentially tax free at the state level. In addition, investing in municipal bonds gives you the satisfaction of investing in community development.
It is important that an investor understand the nuances of municipal bonds in order to make informed decisions. In this comprehensive guide, I will delve into the different types of municipal bonds, unravel the tax implications, examine the benefits and drawbacks, and explore the various methods available for purchasing these bonds. By the end of this article, you will be better informed with the knowledge to navigate the municipal bond market, and seize this investment opportunity that may align with your financial goals.
What are municipal bonds?
Municipal bonds are debt securities issued by local government entities to raise funds for public projects over the long-term. Investors who purchase municipal bonds essentially lend money to these entities, and in return, they receive regular interest payments, which is typically every 6 months, and the repayment of the principal amount at the bond's maturity date. The funds raised through municipal bonds are used to finance critical infrastructure projects, such as schools, community centers, bridges, roads, and more.
What are the types of municipal bonds you can buy?
There are two primary types of municipal bonds investors are likely to encounter:
- General Obligation (GO) Bonds: GO bonds are backed by the issuer's full faith, credit, and taxing power. The issuer leverages its taxing authority to repay the bondholders. GO bonds are typically considered low-risk investments, making them attractive to conservative investors.
- Revenue Bonds: Revenue bonds, in contrast, are backed by the revenue generated from specific projects. These might include toll roads, airports, sports stadiums, or other revenue-generating assets. The repayment of revenue bonds depends on the success and financial performance of the underlying project, making them slightly riskier than GO bonds because the revenue is not guaranteed.
How are municipal bonds rated?
Regardless of whether you invest in a general obligation bond or a revenue bond, they are all given a rating. The rating system is managed by three major credit firms, which are Standard & Poor’s (S&P), Moody’s, and Fitch. The rating takes into account aspects of the issuer such as: creditworthiness, debt burden, economic conditions, historical payment history, and the regulatory and political environment. At the top of the rating structure is AAA, Aa, or A depending on the credit firm, where the issuer is considered to have the lowest risk of default, and tends to offer a lower interest rate. At the bottom end of the ratings is the CCC, which is often referred to as ”High Yield” or “Junk Bonds” that have a higher level of risk, and also offer a higher interest rate.
How are municipal bonds taxed?
Easily, one of the most appealing aspects of investing in municipal bonds is their tax advantage. The interest income earned from most municipal bonds is typically exempt from federal income taxes. Additionally, if you invest in municipal bonds issued within your state of residence, the interest income is often exempt from state and local taxes as well. Each investor should research their local bond requirements to verify the tax advantages. This tax-exempt status can lead to higher after-tax returns compared to taxable investments such as CDs and Treasuries, making municipal bonds particularly appealing to investors in higher tax brackets. However, it is essential to note that certain types of municipal bonds, such as private activity bonds, may be subject to the alternative minimum tax (AMT).
What are the ways to buy municipal bonds?
There are several avenues to purchase municipal bonds:
- Brokerage Firms: Many brokerage firms offer a wide selection of municipal bonds to individual investors. Online brokerages provide a listing of newly issued municipal bonds, or a person can purchase previously owned bonds from a section called the secondary market within the brokerage site. Each option provides available bonds specific to your state.
- Bond Funds: Investors can access municipal bonds by investing in mutual funds or exchange-traded funds (ETFs) that focus on municipal bonds. Bond funds offer diversification and professional management. However, the tax advantage of this investment may be lost with this option because the fund may comprise of bonds from multiple states.
- New Issuances: Investors can participate in new municipal bond offerings when they are first issued. This can be done through primary offerings or directly from the issuer or from a brokerage firm.
Bond Dealers: Some investors may choose to buy municipal bonds directly from bond dealers or banks that specialize in fixed-income securities. This method is less common, and it may require added research to find this option.
What are the benefits and drawbacks of buying municipal bonds?
Benefits of buying municipal bonds:
- Tax Advantages: The tax-exempt status of municipal bonds federally, and possibly at the state level, can result in higher after-tax returns compared to taxable investments.
- Relatively Low Risk: Municipal bonds, especially AAA bonds, are considered to be relatively low-risk investments, offering a level of security for conservative investors.
- Steady Income: Investors receive regular interest payments, typically every 6 months, throughout the life of the bond, providing a stable income stream.
- Diversification: Municipal bonds offer an option outside of the markets for a diversified investment portfolio, helping to mitigate overall risk exposure.
Drawbacks of buying municipal bonds:
- Lower Yields: Municipal bonds often offer a lower rate of return compared to riskier assets, such as mutual funds, ETF, and individual stock.
- Interest Rate Risk: Like all bonds with long time horizons to maturity, the value of new municipal bonds may fluctuate with changes in interest rates. Rising interest rates result in higher rates on new bonds, which can lead to capital losses for investors who sell their bonds prior to maturity.
- Market Liquidity: Selling a municipal bond on the secondary market prior to maturity may result in paper losses, or a much lower rate of return, if competing with higher bond rates on newly issued bonds.
Conclusion
Investing in municipal bonds can be rewarding while providing an additional layer of diversity. Munis also offer a way to build wealth while supporting essential public projects in your local community. As you step into the world of municipal bond investments, gaining a broad understanding of the various bond types, their tax implications, benefits, drawbacks, and the specific purchase options will equip you to make informed financial choices. By capitalizing on the strengths of municipal bonds and diversifying your investment portfolio, you'll be on the path to realizing your financial goals while making a positive impact on the development of your community.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.