A municipal bond is a debt security that is often issued by government entities. Municipal bonds can be used to preserve income while generating a stream of tax-free income. States and cities issue municipal bonds to finance different projects to build new schools, fix the public roadways, or even manage your cities’ plumbing system.
If you are trying to preserve capital, looking into municipal bonds is one option. Bonds can only last for a couple of years or some longer-term bonds may not mature for multiple decades. Municipal bonds can be purchased from registered municipal bond sellers or they can be owned through a municipal bond fund.
How Do Municipal Bonds Work?
With a municipal bond, the lender issues the borrower a set amount of money. The lender then receives a portion of the original amount back with additional interest payments usually on a semi-annual basis in the future. The issuer of the municipal bond will receive specific interest payments throughout a predetermined period.
When this period is over the bond will reach its maturity date and you will receive the original investment amount back. It should be noted that municipal bonds are low-risk, but have lower interest rates than bonds that are taxable.
Types of Municipal Bonds
There are two main types of municipal bonds. The main types of municipal bonds include general obligation bonds and revenue bonds. Investing in municipal bonds can help you preserve capital and generate interest if they’re managed correctly. It is important to understand each type of municipal bond before you make an investment.
General Obligation Bonds
General obligation bonds are not secured by any assets, and the borrower will usually pay them back using tax revenue. There are also types of bonds that are from private institutions such as hospitals and non-profit schools. These bonds are often used to serve the public. The municipality is not liable for the debt if the institutions choose not to pay for the sale of the bond.
Revenue bonds are used to pay for projects that generate income and are not backed by the government. These types of bonds are generally backed by revenues from an income source such as leasing or toll fees. If the source of income begins to dwindle the bondholders will not have any claim on the revenue source.
Other Types of Bonds
There are also government bonds and corporate bonds which are all utilized by investors.
Government bonds are issued by the government to finance government obligations and spending activities. These types of bonds are then used to raise money to fund to pay for different projects and ideas for the country. Investors are able to get paid back through specific pay intervals from the government.
Corporate bonds are issued as a means to increase their financing capabilities to allow them to expand and continue their current operations. When you purchase a corporate bond you are lending money to the corporation that issued the bond.
Corporations make a legal commitment that requires them to pay back the bonds with additional interest. Corporate bonds allow you to receive a series of interest payments in return for you helping them issues such as capital improvement and expansion.
Risks Associated With Municipal Bonds
Call risk is the risk that a bond issuer will redeem a bond prior to it reaching its set maturity date. With a call risk the issuer typically will redeem a bond if the interest rates decline in order to improve their investment and saving money.
Credit risk is the risk of default on a debt due to the borrower facing some financial hardships that prevent them from making payments. With credit risk, you are referring to the possibility that the borrower will be unable to pay back the owed principal plus interest which will interrupt the cash flows of the lender.
Interest Rate Risk
Interest rate risk refers to the effects fluctuating interest rate prices can have on the value of a bond or investment. Investors need to be wary of interest rate risk because bond market prices will decrease as interest rates move up. If interest rates go up it could cause investors to lose money on municipal bonds because their value has plummeted.
Inflation risk is the risk that your investment returns will decrease due a decline in purchasing power. Often times, inflation leads to higher interest rates which lower the value of fixed income securities and government bonds.
Liquidity risk is the risk that investors will not be able to find a market for the municipal bond. This could prevent owners from buying or selling the bond when they so choose, and thus reducing the chance of acquiring their desired price
How Are Municipal Bonds Taxed?
A large portion of the income from municipal bonds is usually exempt from federal taxes. State and local taxes for municipal bonds may be exempt for individuals based on the state where they reside. Bonds in New York City are triple tax-free meaning they’re exempt from federal, state, and local taxes.
How To Invest in Municipal Bonds
Many people ask themselves how can I invest in municipal bonds? You need to do your research before you buy or sell any municipal bonds so that you understand all of the risks.
Online brokers can be helpful if you would like to learn all about investing in municipal bonds quickly. Municipal bonds have transaction costs so it’s important to understand the default risk associated with buy or selling each specific bond.
You can invest in municipal bonds by opening an account with an online broker. Online brokers can help you with exchanges involving the buying and selling of municipal bonds.
Many people look into using an online broker because they’re convenient and they can help you capitalize on important information quickly. Online brokers are licensed and have years of experience managing municipal bonds.
Municipal Bond ETFs
Bonds can even be bought and sold in a secondary market where you can hold them until they’re fully mature. You can purchase municipal bonds from Exchange Traded Funds (ETFs) where bonds can be exchanged. It’s important to know that you don’t physically own the bond if you purchase any Municipal Bond ETFs.
Municipal Bond Mutual Funds
These types of Mutual Funds offer tax-exempt yields that help you diversify your holdings and decrease the risk involved. Municipal Bond mutual funds provide excellent tax efficiency and you won’t feel the need to manage multiple different bonds. You still will have to pay for fees such as expense ratios or sales fees that come along with bond investments.
Financial advisors can help you understand the tax implications of municipal bonds. You should consider hiring a financial advisor to help you maximize your income with municipal bonds and help you navigate through different transactions correctly.
Seeking Out Guidance For Municipal Bonds
You may consider handling all of your financial planning by yourself, or with the help of a financial advisor. If you choose to do your own financial planning you need to understand municipal bond rates and all of the benefits and risks of each transaction. The better bet may be to enlist the assistance of a professional who can help you get started investing in municipal bonds.