Municipal bonds, sometimes known as “munis,” are debt instruments issued by states, cities, counties, and other government bodies to fund public projects including schools, roadways, water systems, and other infrastructure. Local governments rely on these bonds to raise funds for development, while investors benefit from a reasonably safe and tax-advantaged investment.
Key Characteristics of Municipal Bonds
1) Types of Municipal Bonds:
- General Obligation Bonds (GO Bonds): These bonds are backed by the issuing municipality’s complete faith and credit, as well as its taxing capacity.
- Revenue Bonds: These are backed by specific revenue sources, such as bridge tolls or water utility fees, rather than the issuer’s overall credit.
2) Tax Advantages:
- One of the most appealing aspects of municipal bonds is that the interest is usually excluded from federal income taxes. Furthermore, if the bondholder lives in the state where the bond was issued, the interest may be free from state and local taxes.
3) Safety:
- Municipal bonds, particularly GO bonds, are often seen as low-risk investments due to the issuing entity’s taxing power. However, revenue bonds might be more risky if a certain revenue stream fails to fulfill expectations.
Benefits of Investing in Municipal Bonds.
1) Tax Exempt Income:
- The tax-exempt character of muni bond interest can lead to better after-tax returns than taxable bonds, especially for investors in higher tax rates.
2) Capital Preservation:
- Munis are reasonably safe investments, making them ideal for investors looking to protect capital while producing a consistent income.
- Including municipal bonds in an investing portfolio can increase diversification while lowering total portfolio risk.
Considerations for Investors
- Municipal bonds, like all fixed-income assets, are exposed to interest rate risk. When interest rates rise, the value of existing bonds often declines.
2) Credit Risk:
- While municipal securities are generally safe, there is still a possibility of default, particularly with revenue bonds. Investors should consider the issuing municipality’s credit rating.
3) Liquidity:
- Municipal bonds may be less liquid than other forms of bonds, making them more difficult to acquire and sell quickly without impacting the price.
Conclusion:
Municipal bonds are an appealing investment for many because they combine tax-free income, safety, and the possibility for portfolio diversity. They are especially useful for investors in higher tax brackets who want to maximize after-tax gains. When investing in municipal bonds, investors must consider issues such as interest rate risk, credit risk, and liquidity. By carefully examining these factors, investors can effectively include municipal bonds into their investment strategy to meet their financial objectives.
