What Are Municipal Bonds?
by Ben Bontekoe
If you are looking for an investment that provides relatively low risk, along with the promise of regular returns and favorable tax treatment, municipal bonds may be the answer. While not the most glamorous investment, these securities can add safety as well as growth potential to your portfolio. Municipal bonds can help you earn solid returns while helping local and state governments improve services to their residents.
Municipal bonds, or munis, are debt securities that are issued by a city, county, state, school district or other government entity, known as the issuer. The money borrowed from investors is then used to finance a public project such as building roads, schools, bridges or hospitals. The issuer promises to pay the investor a specific interest rate over the life of the bond, as well as return the original amount borrowed on the bond's maturity date.
Investors who prefer to receive a predictable source of income, while keeping their principal secure, may favor municipal bonds. For example, suppose you purchase a 10-year muni for $10,000, with an annual interest payment (called a coupon) of 8 percent. If you keep the bond for the full ten years, you will have received $8000 in interest payments, or $800 per year, as well as having your original $10,000 returned to you.
There are two types of municipal bonds. General obligation bonds raise cash to pay regular expenses. Investors expect to be repaid because of the issuer's power to collect taxes. Revenue bonds are issued to fund a specific project with the intention of using income from that project to repay bondholders. For example, a city may issue bonds to pay for a new water system, with the expectation that they will use future payments from customers to repay their obligations.
The interest paid on many municipal bonds is exempt from federal taxes. Also, many munis are tax-free at both the state and local levels, if you are a resident of the state in which they're issued, making them "triple tax-free." While munis typically pay lower rates than other types of investments, they may actually provide greater returns than taxable securities. Because municipal bonds are backed by government entities, they are generally considered low-risk investments.
Although they are usually safe investments, municipal bonds are not without risk. While it is not likely, there is always a chance that the issuing agency could go bankrupt, causing them to default on the repayment of bonds, along with any interest payments. Also, while many munis are tax-exempt, there are others that are taxable, particularly if you are required to pay the alternative minimum tax. You should consult a tax adviser before deciding to invest in any municipal bonds.