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Municipal bonds appeal particularly to risk-averse bond investors that seek a steady source of income with the priority of capital preservation. With the added tax benefits, the interest paid on the tax-exempt municipal bonds is normally lower than the interest due on comparable fixed income instruments like corporate bonds. Despite the fact that municipal bonds are not backed by the federal government in the manner that treasury bills and treasury bonds are, they are still considered to carry a very low risk of default.
General obligation bonds are issued by states or cities and are NOT secured and backed by asset collateral — rather, GOs are backed by the creditworthiness of the issuer and taxing power of the jurisdiction. While the issuers cannot print money like the federal government, they can tax residents to have enough to pay bondholders and avoid defaulting.
Instead, revenue bonds are backed by the revenue generated by projects or other sources, most commonly highways i. Municipal bond issuers can also raise capital on behalf of entities providing public services e. In the event of default, the issuer — i. Wall Street Prep's globally recognized certification program prepares trainees with the skills they need to succeed as a Fixed Income Trader on either the Buy Side or Sell Side. We're sending the requested files to your email now.
If you don't receive the email, be sure to check your spam folder before requesting the files again. Get instant access to video lessons taught by experienced investment bankers. Login Self-Study Courses. Financial Modeling Packages. Industry-Specific Modeling. Real Estate. Professional Skills. Imagine a relatively safe, long-term investment that generates income, allows you to save on taxes, and funds public projects crucial a community. That's essentially what happens when you invest in municipal bonds, which allow you to invest in the infrastructure of state and local communities while adding diversity and tax efficiency to your portfolio.
Here's what you need to know about municipal bonds, from why they're popular among tax-smart investors to how they can benefit your portfolio. A municipal bond, or "muni" for short, is a type of bond issued by a state or municipality to help fund necessary public works projects. Munis are popular with investors because of their tax advantages.
Interest earned on municipal bonds is usually exempt from federal income tax. If you purchase a muni in the state you live, it could also be exempt from state and local taxes. Earning tax-free income is especially attractive to investors in higher tax brackets. Investors also like the inherent safety of municipal bonds. In most cases, because you are investing in a bond used to help finance infrastructure backed by a local government, you can usually count on getting your principal back at maturity.
At its most basic level, a bond is a loan made by an investor to a borrower. Whereas treasury bonds are issued by the US government and corporate bonds are issued by companies, municipal bonds are issued by local and state governments. State and local governments issue municipal bonds to help pay for a wide range of projects including roads, schools and hospitals. Investors who purchase these bonds lend money to the municipality in return for regular interest payments usually semiannual for a set amount of time.
Principal is repaid when the bond matures, or when the loan ends. Munis have a wide maturity range of one to 30 years. It's important to pay special attention to the type of account you use to purchase these bonds. In a traditional IRA or k retirement account , earnings already grow tax-free.
Most investors find holding munis in taxable brokerage accounts help make the most of munis' tax-free status. In rare cases, municipal bond interest may not be exempt from federal taxes if they are used to fund an activity not qualified for tax-exempt status under IRS rules, like paying pension fund liability. It is usually obvious to you, your broker or your advisor when a muni is not exempt from federal taxes. Investors who buy and sell municipal bonds may be liable for capital gains tax on profits from those sales or for bonds purchased at a discount price.
In addition, if you are subject to the alternative minimum tax, you may be required to pay some taxes on municipal bond interest. Municipal bonds are considered relatively safe investments because they have lower default rates and higher credit ratings than corporate bonds. Plus, many munis are backed by insurance that guarantees payment in the event of a default.
That's not to say munis are immune from default. For example, during the Puerto Rican debt crisis and the Detroit city bankruptcy, there were several muni bonds that could no longer make payments. If municipal bonds pique your interest, it's important to understand credit ratings. This makes it easier for investors to evaluate risk. Like all bonds, munis also carry interest rate risk. When interest rates fall, prices for existing bonds paying higher rates will rise.
In turn, when interest rates rise, prices on existing bonds paying lower rates will decline. If you hold muni bonds to maturity, price risk is not a factor. You only experience the ups and downs if you are buying and selling muni bonds. In return for safety and the tax advantages, investment-grade municipal bonds often yield less than their taxable counterparts, such as corporate and government-issued bonds.
High-yield munis, or munis that come from less-creditworthy issuers, can have significantly higher yields than investment-grade munis ,but they come with more investment risk.
Municipal bonds (or “munis” for short) are. A municipal bond, commonly known as a muni, is a bond issued by state or local governments, or entities they create such as authorities and special. A municipal bond is a debt security that has been issued by a local government entity. Examples of these issuers are state, county and city.