Municipal Bonds – What They Are And How They Work
Although I currently do not have any investment in Municipal bonds, this type of investment is something that I strongly consider in the future.
When it comes to investing, having bond exposure in your portfolio is part of creating a diversified asset allocated risk-adjusted account. This is true no matter what the interest rate environment is currently at. Many people have questions about what bonds are and how they work. As there are different types of bonds, I will focus on educating you on Municipal bonds now.
A municipal bond is where you are lending your money to a particular municipality such as a state, city or locality. In return, you get money as interest payments in return for this with the return of principal at the end of the term. The term is typically over 10 years, more likely 30 years.
Two types of Municipal bonds:
General Obligation Bond – GO
The first is called a General Obligation Bond (GO). This means that the state or city or locality will issue the bond and make the interest payments based on their ability to collect revenue in the form of taxes. This is the most common type of Municipal bond in the U.S.
These particular type of bonds are used to fund different government projects. It is the burden of the taxpayers to repay. And that’s because they have a common benefit like a new school, or roads or government buildings and so forth. They are called pledges and there are two types of General Obligation Pledges. The limited-tax general obligation pledges and the unlimited-tax general obligation pledges.
The second type is called a revenue bond. These type of municipal bonds are project driven. The payment of the interest is based on a collection of revenue through tolls on highway toll roads or ticket sales in the case of a sports stadium or similar project. It is not burdened on the taxpayers in the municipality. Mainly because they may not have a common benefit!
However, in some cases, there is a hybrid of the two, such as a zoo or science museum. These two are both general obligation and revenue driven by ticket sales. The nature of the project will determine it and is usually also put to a vote of the people.
The Tax Advantages
There are some tax advantages under the tax code that will benefit the investor. First, the interest earned on municipal bonds will come to you, federal income tax-free. Because of this feature alone, your interest earned is typically lower than that of corporate bonds, but it is reliable income tax-free income.
Secondly, if you live in the same State that you have invested your bond money in, you usually get a tax-free benefit at the state level as well. These two income tax features translate into a strong income benefit for investors. This is one of the reasons why they are a favorite for retired individuals and those on a fixed income.
However, there are risks involved in Municipal bonds. There is always inflation risk in that the interest earned will not keep up with the pace of inflation. The bond could be called, meaning that they will return the principle to get a better interest rate. They are not always liquid and the credit rating of the issuer could deteriorate over time.
These are just a few of the risks. As a prudent investor, you should weigh the risk versus reward. Make sure your broker/dealer and advisor fully understand them to educate you properly.
How You Can Invest
The best way to invest in them is through your brokerage account. Fidelity has been aggressively marketing bonds as an investment option. Check them out and weigh your options. You can actually invest directly in the bonds after you work with your broker on the best ones for you.
You can also invest through Mutual Funds or Exchange Traded Funds. Keep in mind that because of the nature of these funds you may lose the individual state income tax protection as they invest across states municipalities. Do your research and pay attention to your broker. It’s your money and all the time invested into it should be all worth it.