Municipal Bonds Explained

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muni bondChances are that you have heard about what some think is an impending crash in the municipal bond market. Doomsday predictions about the municipal bond market prompted a drop in issuance for the first part of 2011. Dire predictions about mass defaults have largely failed to pan out this year, though. As a result, interest in municipal bonds is rising again.

Bonds, of course, are basically loans to other entities. In the case of municipal (muni) bonds, you loan your money to a state or local government, and receive the principal back, plus interest. If you are interested in a bond option that has the potential to provide you with decent yields, and tax advantages, municipal bonds might be right for your portfolio. As with all investments, though, it helps to understand how municipal bonds work, and to carefully consider whether or not they will work for you.

Kinds of Municipal Bonds

There are a few main types of muni bonds that you can choose from. As you studying your options, it’s a good idea to consider what works best for you:

  • General Obligation Bonds: If you live in the municipality issuing these bonds, you will be exempt from federal state, and local taxes on the interest earnings (different rules apply if you live outside the municipality). These bonds are paid back through the taxes collected by the authority. These bonds might be repaid through regular taxes, or taxes collected from a specific bond issue.
  • Revenue Bonds: These types of muni bonds have tax benefits similar to general obligation bonds. However, the bonds are repaid through revenue generated by the project. A toll booth might generate the revenue needed to repay a special bond.
  • Taxable Bonds: Some bonds are taxable even if you live in the municipality. These taxable bonds are usually for projects, like professional sports arenas, that don’t provide a truly public benefit. You  might get a better interest yield on a taxable bond.
  • Zero Coupon Bonds: When you get this type of bond, you actually receive the interest you are due at the same time that you receive the principal back. Most bonds pay you interest regularly (often twice a year, or quarterly), but a zero coupon bond doesn’t pay until the bond matures.

You should realize that you can get a floating rate muni bond, or a fixed rate bond. Most of us expect fixed rate bonds, though. These yields can change daily, weekly or monthly, depending on the terms of the bond. A put bond is one that allows you to sell back the bond before maturity. Guaranteed yields come with different dates. This provides a certain amount of flexibility in turning in your bond.

It is possible to purchase muni bonds through your investment broker, and at some banks. There are also bond dealers that specialize in those types of transactions. You will have to pay a transaction fee; you can shop around to see where you can get the best price on the transaction. Check into the minimum requirement, since many muni bonds are bought in increments of $5,000. Make sure you’ve done your homework so you understand what you are getting into, and so that you understand how muni bonds will fit into your financial plan.

(Photo: The.Comedian)

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3 Responses to “Municipal Bonds Explained”

  1. Scott says:

    Thanks for the overview.

    I consider municipal bonds as investments for the wealthy because of their tax advantages. Ordinary investors don’t see the same tax advantages investing in municipal bond; however, there are exceptions. Build America Bonds, which can be bought through the ETFs BAB and BABS, are not tax advantaged, therefore offer better yields. As for their safety – I think it’s absurd for a state to go into default on bonds as long as it has the ability to tax its residents. Sure, there are basket cases out there, but most municipalities will pay their debts or risk being shut out of the debt markets.

    • mannymacho says:

      That is true, they are very safe – not so much that they have never defaulted, but still light years ahead of riskier instruments.

  2. govenar says:

    You didn’t mention that you can also buy muni bonds in a mutual fund or ETF (which gets around the $5000 minimum); though then there’s the issue that the price might go down when interest rates go up.

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