What Is a Municipal Bond?
Let me explain municipal bonds directly: these are debt instruments that local, county, and state governments issue to raise money for public works like building highways, bridges, or schools.
Think of them as loans where you, the bondholder, become a creditor. In return for lending your capital, you get promised interest on your principal, which is repaid by the bond's maturity date. What makes them stand out is that they're often exempt from most taxes, so if you're in a higher income bracket, this can be a smart choice.
Key Takeaways
You can view municipal bonds as loans you make to local governments to support projects like parks, libraries, bridges, roads, and other infrastructure.
The interest they pay is often tax-free, which is why they're attractive if you're in a high tax bracket. General obligation munis draw from taxes on a project or the government's general funds for cash flows. Revenue munis, on the other hand, use income from the project itself.
Understanding Municipal Bonds
A municipal bond is essentially a debt obligation from a nonprofit, private corporation, or public entity, used for projects like schools, hospitals, and highways.
Known as muni bonds or munis, they can provide tax-free income for qualified residents, but they offer lower interest rates than taxable bonds as a trade-off. Municipal bonds generally have lower default rates than corporate bonds, which suits you if you have low risk tolerance.
Types of Municipal Bonds
Municipal bonds are categorized by how they source interest payments and principal repayments, and this affects their benefits, risks, and taxes. Some generate taxable income, like bonds not qualified for federal tax exemption.
A general obligation bond (GO) comes from governmental entities without backing from a specific project's revenue; some use dedicated property taxes, others general funds. A revenue bond secures payments through the issuer or taxes like sales, fuel, or hotel occupancy. If a municipality acts as a conduit issuer, a third party handles the payments.
Risks of Municipal Bonds
Default risk is low compared to corporate bonds, but revenue bonds are more exposed to shifts in consumer behavior or economic downturns than GO bonds. For instance, essential services like water or sewage treatment have steadier revenue than something optional like a park shelter.
As fixed-income securities, their market prices move with interest rates: prices drop when rates rise, and rise when rates fall. Bonds with longer maturities are more affected by these changes, impacting your income more. Most are illiquid, so if you need cash quickly, you'll have to sell other assets.
Many include call provisions, letting the issuer redeem early if rates drop, then reissue at lower rates. This means you lose out on interest and might reinvest at a lower return.
Frequently Asked Questions
You need at least $5,000 to invest in most municipal bonds, as they're issued in those increments. But you can access them through ETFs or mutual funds for smaller amounts.
Terms vary from short (a few years) to long (decades or more).
The benefits include stability for your capital with low default rates, even if interest is lower than riskier options like stocks or corporate bonds. Plus, interest is usually exempt from federal taxes.
The Bottom Line
Municipal bonds are how local governments borrow to build things like community centers or parks. They give you low-risk fixed income and can diversify your bond portfolio effectively.
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