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How do municipal bonds work?

Understanding How Municipal Bonds Work

Introduction

Municipal bonds, also referred to as “munis,” are a type of debt security that state and local governments issue to raise money for public projects and operating costs. This highly specialized section of the bond market is well-reputed for its low risk and tax-exempt status. This fact makes munis an attractive investment option for certain profiles of investors, including high-net-worth individuals who seek tax-adjusted returns and retirement savers who wish to diversify their portfolios. Understanding how municipal bonds work necessitates exploring their issuance, types, tax advantages, risk profile, and ways to buy them.

Issuing Municipal Bonds

Governments in the state, county, and cities as well as other specialized organizations issue municipal bonds. These entities may encompass school districts, public utility companies, and special-purpose districts. The funds raised through this issuance are typically directed towards infrastructure projects such as schools, hospitals, highways, and wastewater treatment facilities. The bond issuance effectively works as a loan between the investor and the issuer. The issuer promises to pay the bondholder the original investment or ‘principal’ amount back at a specific date or ‘maturity’. Additionally, the issuer also agrees to make regular interest payments to the holder until maturity.

Types of Municipal Bonds

There are primarily two types of municipal bonds: general obligation bonds (GOs) and revenue bonds. The issuing municipality’s full faith and credit guarantees that it will use all available resources, including raising taxes and other sources of income, to repay the bond.

On the other hand, revenue bonds are backed by specific revenue streams that result from specific projects or facilities, like highway tolls or hospital fees. If the project incurs a loss, the issuer is not obliged to compensate investors from its other assets or revenue streams.

Tax Advantages of Municipal Bonds

One of the most attractive features of municipal bonds is their tax advantage. The interest earned on munis is exempt from federal taxes. Additionally, if the investor lives in the state where the bond is issued, the state and local taxes may also be waived. This tax-advantaged status increases the effective yield, making munis particularly appealing for investors in high tax brackets.

Municipal Bonds and Risk

Municipal bonds are generally considered lower-risk in comparison to corporate bonds. This is primarily because municipalities have the power to tax its residents in order to fulfill debt obligations. However, munis are not entirely risk-free. When a municipality faces financial difficulty, this impacts their ability to make interest payments and return the principal upon maturity. Before investing their money, investors should review a bond’s credit rating from credit rating agencies to determine the issuer’s credit risk.

Buying Municipal Bonds

Investors can buy municipal bonds either in the primary or secondary market. In the primary market, bonds are bought directly from the issuer at a predetermined price and yield. These bonds are then traded among investors in the secondary market. Investors can also purchase municipal bond mutual funds, which pool together investments in many different municipal bonds, providing diversification.

Final Thoughts

To sum up, municipal bonds offer an attractive investment option for conservative investors seeking a low-risk, tax-advantaged investment avenue. They represent a win-win aspect of public finance where government entities get the funds they need for public projects while investors get a steady, tax-free income stream. Even though the return may be relatively lower than other investment options, the tax advantage and low default risk often offset this downside.

Understanding how municipal bonds work is crucial for any investor considering this investment avenue. It requires a clear comprehension of their issuance mechanism, the difference between general obligation and revenue bonds, the tax benefits and associated risks, and the means to purchase these bonds. By equipping oneself with this knowledge, one can make a more informed decision about investing in this cornerstone of the bond market.