Municipal Bonds: The One Reason to Buy


Municipal bonds (also called "munis") are "debt securities" issued by local governments in order to borrow money.

These types of investments are "backed" by the organizations that issue them, meaning that the local government is the one that pays you interest.


What are Municipal Bonds?


There are two types you need to know: general obligation and revenue.

General Obligation

These bonds are backed by the "full faith and credit" of the issuer (just like most other bonds). The key word is credit. The concept is very similar to your credit card. The banks don't really know if you're going to be able to repay...you got the card based on full faith and credit.

Revenue

These bonds are sold against the future revenue that a project will generate. Simply put, if you're project will bring in a revenue of $200 next year, you might sell a revenue bond for $100 now in order to get some money up front. The bondholder would then have a claim on some of your future revenue.

Munis are issued by several different entities:

  • States
  • Cities
  • Local Government Offices

Invest Safely Dollar Sign Callout

Safe Investing Tip:
Build America Bonds are taxable munis with special tax credits. Visit http://www.treasury.gov/initiatives/recovery/Pages/babs.aspx for more info. Update - This program expired December 31, 2010.



Why Buy Munis?


One word: Taxes.

Because of their unique tax status, the interest that you earn on a munis are almost always exempt from federal taxes.

If you live in the state that issues the bond, you're also exempt from state taxes.

And if you live in a city that issues the bond, you're exempt from city, state, and federal taxes! Not too shabby.

For revenue-based munis, the type of project can also impact your taxes. Interest from bonds sold for "public good" projects or "qualified private activities" are usually free from federal taxes. Interest from munis issued for regular private sector projects are most likely not tax exempt.

Be aware that not all munis are tax-exempt. Certain restrictions do apply, and some munis are subject to the alternative minimum tax. Make sure you check all the facts before buying any investment.


Factors that affect the Price/Interest Rate


Normally, the probability of a local government body defaulting (being unable to pay off loans = bankruptcy) is very low.

"Very low" does not mean that it cannot or will not happen; there are many state and local institutions that struggled to maintain a balanced budget.

When the balance sheet is bad enough to catch the eye of a bond rating agency, a municipal bond's rating might be lowered.

In this case, the government may have to raise rates in order to attract investors. Or, they could lower the price and keep the rate the same.

When you're comparison shopping, keep in mind that comparing the coupon rates of munis and other taxable bonds can be misleading.

Taxes will end up reducing the net income on taxable bonds. This means that a tax-exempt municipal bond has a higher after-tax yield than a corporate bond with the same coupon rate.


Where Can You Buy Munis?


Municipal bonds can be purchased from your investment broker, using almost any trading account.

If you're worried about the price tag check out "mini-munis". They are designed for bond investors with smaller budgets.



Can't find it? Search the Site!


Sponsored Links