What are Municipal Bonds?
A municipal bond (or Muni) is a debt security issued by governmental agencies usually state or local which may include schools, cities, counties, airports, seaports or redevelopment agencies among others. These sort of securities are appealing to investors because the interest income is often tax-free. Making it a good inclusion in anyone’s investment package.
The Purpose of Municipal Bonds
Tax-free municipal bonds are a way for governmental agencies to raise money to use for public objectives. The bond issuer receives money from the bond holder with the promise of paying back the money with interest and issuing payments within a period of time which could be several months up to 40 years or longer.
The bond holder will often accept a lower rate of interest due to the non-tax status. However, not all municipal bonds are interest income tax exempt. The bond holder should understand all aspects and details regarding the particular bond they will be holding.
Types of Municipal Bonds
Before investing in municipal bonds, the investor should know the different types.
General Obligation Bonds usually carry a lower interest rate as they are the safest type of municipal bond. The promise to repay on the bond is backed by the good faith and credit of the bond issuer (city, county or state).
Revenue Bonds promise to pay from revenue earned from the project for which the money is used such as a utility receiving money from customers.
Assessment Bonds promise to pay the bond holder from property taxes collected within the bond issuers territory.
Bond Rating Agencies
The probability of payment is decided by independent reviewing agencies. There are three primary agencies in the U.S., Moody’s, Fitch and Standard & Poor’s. The bond rating issued to a particular municipal bond is very important in the decision made by the potential bond holder. The lower the rating the higher the risk, but they will most likely be high-yield municipal bonds.
Investing in Municipal Bonds
Investing in Municipal bonds is a good choice to add to anyone’s portfolio. However, if you are close to retirement, you may not want to hold extremely long term bonds. Approximately 50% of municipal bonds are insured. Those that are insured will always be a safer bet. However, they may not be the higher yielding bonds that are so attractive.
Before deciding to invest in a particular municipal bond, investors should know who is the responsible party for servicing the bond interest payments and the economic situation of the governmental territory. Security analyst, Benjamin Graham, suggested looking for the following characteristics in a bond issuers location:
* Should have a population of 10,000 or more
* Should have a varied economy with a primarily higher citizen net worth
* Should have a prompt payment history
Just because it is a governmental agency that issues the municipal bond, it does not mean it is a safe investment. Consider the situation in a simpler theory. Is it better to lend money to a small market owner who pays his bills on time or an emperor who has an empty vault in the castle?