Municipal bonds are a form of debt security issued by municipalities (such as cities, counties, and states). Capital expenditures, such as the building of roads, bridges, or schools, are regular recipients of such offers. Bondholders of municipal bonds are essentially lenders to the issuer. Bond investors receive interest payments and the principal of their investment back at the bond’s maturity date. Investors in higher tax brackets may also find municipal bonds appealing because of their potential tax-free status. This article explains the rates, and how to buy municipal bonds. We also explained the differences between municipal bonds vs Treasury bonds. Enjoy the ride!
What Are Municipal Bonds?
Municipal bonds are an option worth examining if you’re an investor who prioritizes capital preservation and tax-free income. Debt obligations made by governments are called municipal bonds (or munis for short). Buying a municipal bond is similar to making a loan to the issuer for a period of time in exchange for regular interest payments. The bond matures, or expires, at the end of that time period, and you receive your initial investment back in full.
How Municipal Bonds Work
Although there are two types of municipal bonds, taxable and tax-exempt, the latter usually attracts more interest due to the fact that its holders are exempt from paying federal and, in many cases, state and local income taxes on its interest and dividends. Investors who are susceptible to the AMT should speak with a tax professional before purchasing MBs, as interest income from these bonds will be subject to AMT.
Types of Municipal Bonds
There are different kinds of municipal bonds based on the frequency of interest and principal payments. There are a wide variety of structures, each with its own set of advantages and disadvantages in terms of taxes. MB is popular among high-income earners since their interest is exempt from federal income tax. However, not all municipal bonds are free from federal income tax. It is also important for you to get familiar with the types of MBs available. The following are the types of MB:
#1. General Obligation Bond
Bonds with a general obligation are issued by the government and are not backed by any particular revenue stream. As a result, there is an inherent greater potential for loss with these bonds.
#2. Revenue Bond
Governments will sometimes issue bonds backed by the money they expect to make from a specific public works project called “revenue bonds.” It may be collected through tolls or taxes like those on purchases, the value of a home, etc. However, bond yields are sensitive to changes in revenue collected from the sources.
Municipal Bond Rates
Three major rating agencies place bond issuers in order of how likely they are to pay their financial obligations rather than defaulting on them. S&P Global (NYSE: SPGI), Moody’s (NYSE: MCO), and Fitch are these organizations.
The municipal bond rates tend to go down when the issuer’s credit rating goes up. In contrast, lower-rated issuers typically need to charge higher interest rates to compensate for the greater risk they pose. However, municipal bond rates can shift over time. A stable issuer rating is no guarantee against a downgrade in the event of a deterioration in the issuer’s financial condition.
Even in the event of a default, investors in MB have a good chance of recouping their initial investment, but they may be unable to recoup any lost interest. When deciding on MB to purchase, it is important to weigh all of the potential outcomes.
How to Buy Municipal Bonds
It is still possible to buy municipal bonds through a broker. You can keep tabs on bond prices, credit ratings, and more with the help of these firms, which provide self-directed investment accounts. For instance, TD Ameritrade’s Bond WizardTM provides access to a wide variety of bonds (including munis) from which to make an investment. TD’s bond transaction price is a flat $1, though there may be additional fees when purchasing MB. Merrill Edge’s research tools are equal to those of its competitors, although bond investing with Merrill Edge may be more expensive.
Municipal bonds are often purchased one at a time by investors. However, you can also purchase them through mutual funds and exchange-traded funds (ETFs). If you don’t have a lot to put into investments, these are ideal for you. Investing in a variety of MB can be costly, but exchange-traded funds (ETFs) and mutual funds can spread your money out among several different bonds for a low fee.
Perhaps you don’t feel confident making investment decisions on your own, and that includes MBs. If this is how you feel, it could be time to talk to a financial advisor. Advisors often recommend MBs to customers who are less willing to take risks with their money. Your financial advisor will often help you determine if MBs are a good fit for your portfolio based on your individual risk tolerance, investment horizon, and other criteria.
Tax-Free Municipal Bonds
The federal government typically does not tax municipal bonds. (The only exception is if the bondholder owes alternative minimum tax and the issuer of the bond is a private corporation rather than a government). At the state and local levels, some municipal bonds are tax-free.
Noting that interest profits on MBs are included in your adjusted gross income and could increase the amount of your Social Security that is taxed is important because many municipal bond investors are retirees.
Municipal Bonds vs Treasury Bonds
Both municipal bonds vs treasury bonds pay interest to investors, but interest earned on treasury bonds is taxable whereas interest earned on municipal bonds is not.
Local governments sell municipal bonds to raise money for initiatives such as building new roads and schools. Similar to Treasury bonds, interest on municipal bonds is paid out semi-annually. However, unlike T-bills and T-bonds, local government insolvency and bankruptcy make MBs riskier.
Risks with Municipal Bonds
The risk of default on MB is low because they are backed by local governments rather than the federal government. Nonetheless, compared to corporate bonds, municipal bonds continue to be the safer option. Most MB includes a call option. A bond with a call provision can be redeemed by the issuer before its maturity date. Investors run the risk of losing money if the bond is called before its maturity date.
When interest rates in the market are low, issuers may choose to activate a call provision. The reason for this is that they can retire a bond carrying a higher interest rate and replace it with a new bond carrying a lower rate.
What Do Municipal Bonds Pay For?
Municipal bonds can be issued for the sole purpose of funding a government agency’s regular activities and costs. However, the proceeds from municipal bond sales are typically allocated to specific projects that will benefit the local community. Municipal bond money is typically used for public works projects like building new schools, roads, bridges, libraries, and parks.
How Is the Income from Municipal Bonds Taxed?
The federal government does not tax the interest earned on MBs. Even at the state or local level, it is often not subject to taxation if the bond purchaser resides in the issuing municipality, county, or state. Treasury and corporate bond interest, on the other hand, is subject to federal income tax. Even if the yield on a Treasury bond is higher, an investor may still choose a municipal bond over it if the after-tax yield on the municipal bond is higher. When comparing MB to other debt securities, investors should keep their tax levels in mind and look at post-tax yields.
Consider two hypothetical 10-year $10,000 bond investments: one is a 3.5% yielding municipal bond, while the other is a 4% yielding 10-year bond issued by the United States Treasury. An investor in the 20% federal income tax bracket would benefit more from the $350 annual return on the municipal bond than the $320 annual return on the treasury bond ($400 minus $80 in taxes).
How Dangerous/Safe Are Municipal Bonds?
Debt securities, such as bonds, are generally much safer than equity securities, such as stocks, and most derivative products, such as options. However, how do munis stack up against other bond categories? MBs have a far lower default risk than corporate bonds due to the fact that they are backed by either income-generating projects (in the case of revenue bonds) or income tax (in the case of general obligation bonds). However, there is some default risk even for governments at the municipal, county, and state levels.
Furthermore, although this does not make munis “risky,” per se, it is important to remember that individual MB is significantly less liquid than stocks or exchange-traded funds that include bonds. This implies that trading them is typically not as simple as tapping a button on a trading program. Since there are fewer buyers and sellers, transactions may take longer than usual, and the bid-ask spread may be wider than expected.
What Is the Minimum Amount You Need to Invest in Municipal Bonds?
The most common denomination for municipal bonds is $5,000. Some exchange-traded funds (ETFs) and mutual funds may include municipal bonds, allowing investors to buy bond portions.
What Are the Benefits of a Municipal Bond?
Municipal bonds provide safety for your capital and have low default rates, but their interest rates may be lower than those of riskier investments like corporate bonds or equities. Also, the federal government does not tax the interest earned on muni bonds, making them a desirable financial instrument.
Should You Invest in Municipal Bonds?
You’ll have to consider your own financial condition and objectives before answering this question. As with other bonds, the primary appeal of these is reduced exposure to loss of principal in exchange for lower potential total returns. When investing in funds where you want to avoid the possibility of permanent loss, or as a component of a diversified portfolio of stocks and bonds, this is of paramount importance.
MB has a lesser risk of losses and may offer tax benefits that result in a greater after-tax yield, thus these factors should not be overlooked when comparing munis to corporate bonds.
Are Municipal Bonds a Good Investment?
Although muni bonds have historically been favored by the wealthy, investors of all income levels may benefit from owning them. It’s possible that MB, as a high-quality investment, could help you ride out economic downturns.
Can You Make Money on Municipal Bonds?
The interest you receive from municipal bond issues is exempt from federal income tax, and if you reinvest that interest, your earnings grow tax-free. The after-tax returns on MBs (or “munis”) are higher than those on comparable taxable corporate or government issuance.
How Long Do You Hold Municipal Bonds?
Bonds with a maturity of one to three years are called “short-term,” while those with a maturity of ten years or more are called “long-term.” Municipal bond interest is often free from federal income tax. If you live in the state where the bond was issued, the interest you earn from it may also be free from state and local taxes.
Do Municipal Bonds Pay Monthly?
Interest on municipal bonds is often paid semiannually, while interest on notes is typically paid at maturity.
Final Thoughts
Municipal bonds are a type of bond or fixed-income security that can be issued by a local, county, or state government to raise money for public works projects. You may also hear people refer to municipal bonds as “muni bonds” or just “muni.” Municipal bonds offer investors a tax advantage because their interest and principal payments are not taxable. That’s why it’s such a great investment for people in higher income tax brackets.
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