A municipal bond is a bond issued by a local government to raise money for things like infrastructure improvements or investments in schools. When you buy a bond, you’re lending money to the issuer. You receive interest payments at regular intervals and get your money back when the bond matures. Municipal bonds aren’t generally considered to be as rock-solid as Treasury bonds.
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What Is a Municipal Bond?
City, county and state governments issue municipal bonds to raise money, say for a new hospital or road. The most common types of municipal bonds are general obligation (GO) bonds and revenue bonds. A general obligation bond is backed by the credit of the city and state in which the bond is issued, on the assumption that the local government a) can raise money from taxes and b) won’t default. A revenue bond is backed by the revenue that will be generated by the project the bond funds – think tolls on a new road, for example.
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Municipal Bond Prices and Interest Rates
Municipal bonds offer a fixed rate of return in the form of interest, usually paid out every six months. If you buy an individual bond, this interest doesn’t compound. You simply receive the money in regular, tax-free intervals semiannually.
The general interest rate, the one you hear about on the news when the Federal Reserve (the “Fed”) makes announcements, has an inverse relationship with bond prices. When the interest rate goes up, bond prices go down. When the interest rate goes down, bond prices rise. While you hold your bond, its price is fluctuating with interest rates. So, if you sell a bond before maturity, expect to get what the bond is worth at the time you sell it, even if that’s less (or more) than what you paid.
Tax-Free Municipal Bonds
The money an investor receives in interest payments and returned principal from municipal bonds is free from federal income tax and, in many cases, from state and local taxes. It may be subject to the Alternative Minimum Tax, however.
How to Buy Municipal Bonds
If you want to buy municipal bonds, you can either buy each individual bond through a broker or invest in many bonds at once, through a bond fund, mutual fund or Exchange Traded Fund (ETF). If you want to buy individual bonds, you’ll need plenty of money to invest, and you’ll be responsible for choosing low-risk bonds and diversifying your holdings. On the other hand, if you buy a bond fund, you’ll have built-in diversification without taking the time to investigate each bond.
As far as fees go, some analysts say that there isn’t much of a difference between buying individual bonds and buying a fund. Funds come with an explicitly stated expense ratio (0.2%, say). Individual bonds do not, but the brokerage’s commission fees are generally included in the price you pay. With a bond fund, you can reinvest the interest payments you receive each month. With individual bonds, you’ll have to wait until the cash you accumulate in interest payments equals the amount you need to buy another bond.
If you go the route of choosing a bond fund, you can choose your fund based on several factors. You can buy single-state funds or national funds that hold bonds from many states. You can buy funds that have long terms or funds with short terms, depending on when the bonds mature. If you’re chasing yields, you can buy funds with non-investment grade bonds that offer higher interest payments to compensate for their higher risk of default.
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Municipal Bonds vs. Treasury Bonds
Let’s compare municipal bonds with Treasury bonds. Treasury bonds are considered to be safe and dependable places to stash investment money. When stocks fall, as in a recession, investors generally flock to Treasury bonds. People in or near retirement also tend to favor Treasury bonds. The bonds are backed by the “full faith and credit” of the US government, and the risk of a default is negligible.
Cities, on the other hand, can default and go bankrupt. “Investment grade” bonds are bonds that have a very low risk of default, but there are plenty of other, non-investment grade bonds.
Interest from Treasury bonds is exempt from state and local taxes, but is subject to federal income taxes. Interest from municipal bonds, as we’ve covered, is exempt from federal taxes, but not necessarily exempt from state and local taxes. Remember how we said that municipal bonds are riskier investments? Well, as a result, the interest rates on municipal bonds are generally higher than on Treasury bonds.
Municipal bonds are often attractive to investors who are eager to cut their federal tax bill. In many cases, if you live in the state that is issuing the bond you buy, the interest will be exempt from state income taxes, too. But if paying low taxes is your main financial priority, you’d probably be well served by talking to a tax professional before you take the plunge and spend thousands on municipal bonds.
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