What Is a Municipal Bond?

Municipal Bond meaning

Municipal bonds are debt instruments issued by city and local governments. They are also used to raise money for capital investment in local projects. Such as schools, streets and highways, bridges, hospitals, public housing, and utilities.

Municipal bonds bear interest paid as either a fixed or variable rate, depending on the terms of the bond. The issuer of the bond receives a cash payment from the investor in return for agreeing to pay the scheduled rate of interest to the bond holder. Interest is then paid over an agreed upon period of time that varies from a few months or sometimes longer. Once the bond matures (i.e. the term of the bond concludes), the investor is then reimbursed the face value of the bond.

Types of Municipal Bonds

Municipal bonds are generally issued as one of three types of debt obligation:

• General Obligation (GO) Bonds. Repay based on the “full faith and credit of the issuer” and are also considered the most secure type of bond. Because they carry the lowest interest rate.

• Revenue Bonds. Repay from a specified future stream of income. Such as a utility or payments from customers or tenants.

• Assessment Bonds. bind repayment from property tax assessment within the municipality.

Returns vary between municipalities. This makes research an essential part of municipal bond investing. But, municipal bond ETFs and mutual funds will do a part of this research for you. And can be a lifesaver for investors with busy schedules.

Pros & Cons to Municipal Bond Investing

An examination of the pros and cons relative to your financial situation and goals. This helps you determine whether investing in municipal bonds is profitable or not.

Advantages

1. Free from Federal Taxes. No one likes handing over a chunk of cash to the tax man. If you are in a high tax bracket or are seeking to create a tax exempt income stream for retirement. Then municipal bonds might be the thing to supplement your traditional pension investments. This tax refuge offers liquidity and tax efficiency all in one. A godsend to those in the highest tax brackets.
2. Free from State and Local Taxes. Municipal bonds are not only exempt from federal taxes. But if you play your cards right, you might dodge state and local taxes as well. Investments in local municipal development projects are also exempted from local taxes. Besides federal taxes.
3. Tax Advantaged Compound Growth and/or Income. Sheltering your investment from taxes allows growth more than in a taxable account. Municipal bonds purchased through a mutual fund or ETF allow you to reinvest bond income. Which then results in compound growth.
4. Lower Volatility Than Stocks (Fixed Income Assets). If the volatility of the stock market leaves your stomach churning. You may want to switch to an asset class with somewhat lower volatility. Municipal bonds have been one of the safest places to park your savings. Providing tax exempt returns and a generally much better return on invested capital. Than either FDIC insured accounts or Treasuries.
5. High Level of Liquidity. Municipal bonds are liquid and are also traded on a secondary market. This means that the capital can be also accessed incase of emergency. And without incurring a tax penalty. This is especially true for investors who invest via ETFs or mutual funds.

Disadvantages

1. Bond Yields May Not Beat Inflation. If you’re not investing in municipal bonds for current income. You’ll want to consider how your bond investment will hold up to inflation. Municipal bonds are often a conservative investment and they also offer tax advantages. their yields tend to be low. Thus, they are less likely to beat inflation than many other investments, such as stocks. This means the money you have parked in a bond fund could be worth less in buying power a few years from now than it is today.
2. Opportunity Cost. If you decide to invest in municipal bonds, take a look at the equation above to calculate your taxable equal yield. Running this ensures that municipal bonds make sense than a taxable bond investment. If you are in a low tax bracket, you won’t be able to capitalize on the tax advantages of a municipal bond. As much as someone in a high tax bracket. Moreover, you may give up the opportunity to realize the higher return on a comparable taxable bond if you invest in a municipal bond instead.
3. Interest Rate Risk. When interest rates go up, current bonds lose value. This is because bonds that carry a lower interest rate must sell at a discount to equal current bond yields. This is less of a concern if you plan to hold the bonds to maturity. but it can still be a difficult pill to swallow if you have to cash out bonds or bond funds when they are trading at less than face value.
4. Risk of Default and Loss of Capital. Any investment carries risk. Municipal bonds are no different. Although, it’s been rare, there’s always the chance the municipality could go belly up. In which case your interest payments and principal would loose.

How to Invest in Municipal Bonds

Generally speaking, there are two ways to invest in municipal bonds. Or through a municipal bond fund. Investors can buy bonds from a municipality through their bank or broker. This method offers investors the comfort of knowing what bonds they own within their portfolio. Such as general obligation, revenue, or assessment bonds. As well as the exact term and yield offered by the investment.

The second way to invest in municipal bonds is to buy shares in a municipal bond fund. This method offers instant diversification across many municipal bonds. This can reduce risk for investors. Another significant advantage is the increased liquidity available via bond funds. Fund shares can sell at any time, so investors will have no problem unloading their bonds for any reason.