What is a municipal bond?
Municipal bonds or “munis” as they are referred to by those more acquainted with the term, are bonds issued by city, county, or state governments. Typically, the bond is used for building a school, community center or another type of local project. There are several aspects to consider when becoming involved with municipal bonds.
Municipal bonds are issued by counties, cities and states in order to raise money to fund specific projects within the said region. The ability to issue bonds is governed by a set of laws and regulations, which vary depending on location. The issuer will be given cash for the bond and promise to repay the bond to the investors over a set period of time with interest. Length of repayment varies with the bonds.
Types of municipal bonds
The first basic question to consider when approaching municipal bonds is the type of bond to go for. The most popular kinds of bonds are general obligation bonds and revenue bonds.
- General obligation bonds generally are voter-approved and based on the credit and good faith of the issuer. In this case, the bond would be repaid by the taxing authority of the issuer.
- Revenue bonds are the other choice in municipal bonds. This type of bond has similar tax benefits as the general obligation bonds, but the method it is repaid differs. Revenue gained by the facility built will be used to repay the bond. An example would be using a toll booth to collect money or perhaps the bills paid at a utility company would be put toward payment of the bond.
Information on taxability
One of the most alluring aspects about municipal bonds is the tax exemption. Municipal bonds that are used for projects to benefit the public as a whole are generally tax exempt from Federal taxes. However, the buyer of the bond may have to live in the state for it to be tax exempt at that level.
Municipal bonds are primarily used as a way to generate tax-free income while preserving capital. While they have a much lower default rate than corporate bonds, they are not without risk. The most secure municipal bond is the general obligations bond. This bond is issued on the basis of the credit of the issuer and typically holds a lower interest rate (as do municipal bonds in general). This ensures that the issuer is more likely to repay based on credit history. Revenue bonds can be a bit risky because the promise to repay is centralized on revenue obtained from the project. If there is no revenue, or not enough, repayment is compromised.
Ratings agencies, to include Standard & Poor’s and Moody’s, will assign a bond rating based on the level of risk that they determine the bond carries. These third party reviews are very important when looking at bonds.
Interest rate risk: Because bonds can be bought and sold once they are issued, they do fluctuate in price above and below their fixed face “par” value. While bonds may drop in value if the ability of the issuer to repay is called into doubt, they are more broadly affected in price by interest rates. Basically, since investors can get better returns than bonds elsewhere when rates are rising, since they were issued at a fix rate before interest rates went up, bond prices generally fall with interest rate increases. With fixed bonds offering better rates than can be found elsewhere when rates are falling, their prices will increase when rates are going down. More about this and other types of bonds can be found at what are bonds.
Inflation risk: Apart from potentially driving up interest rates, higher inflation reduces the purchasing power of the interest bonds pay and makes them less attractive.
Call risk: If the bonds have a “call date,” the issuers have the option of calling those bonds at any time from that date if it is advantageous to them. In much the same way as homeowners refinancing homes, bond issuers can pay off or reissue their bonds at lower rates.
Liquidity risk: Although municipal bonds are generally held for the longer term, investors sometimes want to sell them before they reach maturity. If there is no active market for the bond, buying or selling will take more time and pricing will become difficult.
Repayment schedules vary with every type of bond. However, most municipal bonds will pay interest twice a year, unless they are short term and pay entirely on maturity.
Who should buy bonds?
Since bonds generally have reduced risks, they offer lower returns than stocks do on average over time. The overall low risk of municipal bonds, combined with the tax-free income they offer, further lowers the returns issuers need to offer to find buyers for the bonds. All of this means that bond investors in the higher tax brackets will likely be better off in municipal bonds after taxes while those in lower tax brackets may earn higher after-tax returns with corporate bonds.
An equation for estimating which is better goes as follows: municipal bond yield/1-tax bracket. This formula as well as other bond calculations with examples can be found at this bond calculator.
Buying municipal bonds
Remember that bonds can either be purchased directly from the issuer on the primary market or from other bondholders after they are issued on the secondary market.
For greater diversity and easy liquidity, bond mutual funds or exchange traded bond funds are a good option. Both mutual funds and ETFs offer investors ways to buy into a pool of bonds instead of purchasing them separately.ETFs vs. mutual funds further explains the relative merits and disadvantages of each.
For those who decide to purchase bonds outside of funds, web sites to include www.bondmarket.com provide extensive information on bonds and prices. Brokers, both full service and online, offer the easiest way to buy bonds. Consider potential risks as well as returns, to include the value of the tax benefit, before making any final decisions.