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The Truth About Municipal Bonds
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At the end of that period, the bond reaches its maturity date , and the full amount of your original investment is returned to you. How Municipal Bonds Work While municipal bonds are available in both taxable and tax-exempt formats, the tax-exempt bonds tend to get the most attention because the income they generate is, for most investors, exempt from federal and, in many cases, state and local income taxes.
Investors subject to the alternative minimum tax AMT must include interest income from certain munis when calculating the tax and should consult a tax professional prior to investing. Key Takeaways Municipal bonds are good for people who want to hold on to capital while creating a tax-free income source. General obligation bonds are issued to raise funds right away to cover costs, while revenue bonds are issued to finance infrastructure projects.
Both general obligation bonds and revenue bonds are tax-exempt and low-risk, with issuers very likely to pay back their debts. Buying municipal bonds is low-risk, but not risk-free, as the issuer could fail to make agreed-upon interest payments or be unable to repay the principal upon maturity. Types of Municipal Bonds Municipal bonds come in the following two varieties: general obligation bonds revenue bonds General obligation bonds , issued to raise immediate capital to cover expenses, are supported by the taxing power of the issuer.
Revenue bonds, which are issued to fund infrastructure projects, are supported by the income generated by those projects. Both types of bonds are tax-exempt and particularly attractive to risk-averse investors due to the high likelihood that the issuers will repay their debts. Credit Risk Levels of Municipal Bonds Although buying municipal bonds is low-risk, they are not entirely without risk.
If the issuer is unable to meet its financial obligations, it may fail to make scheduled interest payments or be unable to repay the principal upon maturity. Bonds rated 'BBB', 'Baa', or better are generally considered appropriate investments when capital preservation is the primary objective. To reduce investor concern, many municipal bonds are backed by insurance policies guaranteeing repayment in the event of default. Every year, Moody's Investors Service publishes "U.
Municipal Bond Defaults and Recoveries," a proprietary study on more than 10, municipal bond issuers it covers. The most recent study covers defaults from to Over the past 10 years, the average default rate for investment grade municipal bonds was 0. Nevertheless, municipal bonds defaults are not uncommon. There were 10 defaults in , seven of which were associated with Puerto Rican debt crisis. The year average default rate for investment grade municipal bonds was 0. Investors who anticipate a significant drop in their marginal income-tax rate may be better served by the higher yield available from taxable bonds.
Call Risk Many bonds allow the issuer to repay all or a portion of the bond prior to the maturity date. The investor's capital is returned with a premium added in exchange for the early debt retirement. While you get your entire initial investment plus some back if the bond is called, your income stream ends earlier than expected.
Market Risk The interest rate of most municipal bonds is paid at a fixed rate. This rate doesn't change over the life of the bond. However, the underlying price of a particular bond will fluctuate in the secondary market due to market conditions. Changes in interest rates and interest rate expectations are generally the primary factors involved in municipal bond secondary market prices. When interest rates fall, newly issued bonds will pay a lower yield than existing issues, which makes the older bonds more attractive.
Investors who want the higher yield may be willing to pay more to get it. Credit ratings seek to estimate the relative credit risk of a bond as compared with other bonds, although a high rating does not reflect a prediction that the bond has no chance of defaulting. Interest rate risk. If bonds are held to maturity, the investor will receive the face value amount back, plus interest that may be set at a fixed or floating rate.
If they move higher, investors who hold a low fixed-rate municipal bond and try to sell it before it matures could lose money because of the lower market value of the bond. Inflation risk. Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest.
It also can lead to higher interest rates and, in turn, lower market value for existing bonds. Liquidity risk. Many investors buy municipal bonds to hold them rather than to trade them, so the market for a particular bond may not be especially liquid and quoted prices for the same bond may differ.
In addition to the risks, what other factors should you consider when investing in municipal bonds? Tax implications. Consider consulting a tax professional to discuss the bond's tax implications, including the possibility that your bond may be subject to the federal alternative minimum tax or eligible for state income tax benefits.
Broker compensation. Most brokers are compensated through a markup over the cost of the bond to the firm.
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