GUIDE TO MUNICIPAL BONDS – THE BASICS
Investing in municipal bonds is a popular way to minimize risk, and generate a tax-free return on the money invested.
WHAT ARE MUNICIPAL BONDS?
Municipal bonds, or munis, help fund public projects such as schools, highways or airports. When an investor buys a bond, the money is a loan to the city, state or agency responsible for the project.
The issuer promises to pay back the loan, with interest, over a set period of time. An investor can buy bonds through a broker, from the issuer, or from another bond holder.
There are two types of municipal bonds.
*Public purpose bonds are tax-free municipal bonds. The money supports public government projects. Interest on the bond is exempt from all federal taxes, and often from local taxes as well.
*Private purpose, or private activity bonds, fund both the government and a private entity. Some private purpose bonds are subject to taxation.
The source of funds for repayment also determines the type of bond issued.
*General obligation bonds help fund public needs such as schools. The issuing agency pays investors back with monies raised through taxation.
*Revenue bonds help fund activities that generate income, such as a toll bridge or airport. The issuer pays back investors through the revenue generated by the project.
Bonds have fixed or variable interest rates. The interest rate is also known at the coupon rate, due to the once-popular practice of attaching redemption coupons to the bonds. A fixed interest rate guarantees a set return, while a variable interest rate fluctuates over time.
Short-term municipal bonds usually mature after one to three years. Long-term bonds mature over ten years or more. Some bonds continue earning interest after maturity. Others repay the full principal to the investor, who can then re-invest the money, or spend it elsewhere.
Municipal bonds usually pay interest semi-annually. Schedules of repayment differ, depending on the bond.
Short-term bonds pay interest until they mature, while longer term bonds make annual principal payments. Zero coupon, or capital appreciation bonds, accrue interest and pay both interest and capital when the bond matures.
Bond issuers are subject to a credit rating system, from AAA to DDD, with AAA being the most reliable. Government bonds generally have an AAA rating.
Municipal bonds are known as conservative investments. High-yield bonds such as speculative or junk bonds come with a high risk. The company issuing the bond could run into cash flow problems or otherwise default on payments. Municipal bonds have a lower rate of return, but the risk is much less.
Like any investment, bonds are never risk-free. Fluctuating interest rates and an unstable market can drive down the value.
Some bonds have a call option, meaning that the issuer can call back the bond before it matures. Some issuers use this tactic when the chance for a better interest rate arises elsewhere.
An investor can be penalized for redeeming a bond before the maturity date. Also, bonds issued for certain purposes may be subject to an alternative minimum tax.
Compared to other forms of investment, municipal bonds are fairly secure. Most investors buy bonds for the tax benefits, as well as the low risk. Municipal bonds can help strengthen and diversify a basic investment portfolio.