Investing in Municipal Bonds

Investing in Municipal Bonds is a money growing strategy that is often overlooked ... photo by CC user Simon Cunningham on Flickr

Municipal bonds are a way for governments such as state, county and other governmental entities to borrow money from people. When a person buys a municipal bond, the government owes that person their money back with interest. The interest is paid on a regular basis, which may be monthly or semiannually, and when a specific time has passed, called the maturity date, the government must repay the original purchase price. The main uses of these bonds are to build schools, repair or build roads, upgrade or add new sewer systems, build hospitals and other projects that are for the public good. Investment experts such as Patrick Dwyer Merrill Lynch may include municipal bonds in their client’s portfolio. 

Tax Considerations

Some municipal bonds offer income tax exemption from both state and federal income tax. There are also municipal bonds that are taxed at the federal level but not at the state or local level. Often the residents of the state of issuance don’t have to pay state or local tax. 

Taxable municipal bonds offer yields that are comparable to other taxable investments such as U.S. government bonds and corporate bonds. These taxable bonds have become more and more popular over the past five years. The four main bond issues that are federally taxable are:

• Local sports facilities
• Investor-led housing
• Replenishing a municipality’s underfunded pension plan
• Refunding of a refunded issue

The Most Common Municipal Bonds

• Revenue bonds are backed by a specific source of funds such as a toll on a highway or lease fees on property. A non-recourse bond means that if the above revenue stream stops, the bondholder cannot make a claim on the underlying revenue source.

• General obligation bonds are not secured by assets. They are backed by the full faith and credit of the issuer or government that can tax residents to pay the bondholders. 

• Conduit bonds are issued by a municipality on behalf of a private entity such as a non-profit college or hospital. The private entity repays the issuer who in turn pays the bondholder. If the private entity fails to make a payment, the bondholder usually doesn’t get paid. 

What is Electronic Municipal Market Access (EMMA)?

People who are considering investing in municipal bonds can get information at EMMA. This is a website with information that includes:

• A bond’s official statement and disclosure documents that are similar to a prospectus and include important features such as type of bond, its yield, maturity date, call features, credit quality and risk factors. Other features are material event notices, audited financial statement, ratings changes, non-payment related defaults and payment delinquencies. 

• Price data that is real-time as well as historical. This includes information about a variable rate demand obligation municipal bond that has periodic interest rate changes. When bonds do not trade frequently, there may not be recent price information available on this site. 

Municipal Bond Investment Risks

Any investment has a certain amount of risk including municipal bonds. Some of the risks include:

• The risk that the issuer cannot pay interest and principal in full due to financial difficulties. This is called default, and investors can get a credit rating for many bonds that will estimate the amount of risk involved compared to other bonds.

• The risk that the issuer will call to repay the bond before its maturity date. This may happen if interest rates drop. Many municipal bonds are callable, so the investor needs to research a bond’s call provisions.

• The risk that the market value of the bond changes with the fluctuation of the interest rate. If the interest rate goes up, the market value of the bond will go down, and if the interest rates go down, the market value will rise. If interest rates go up, the investor will lose money if he or she sells the bond before maturity because the market value will have gone down.

• The risk of inflation. If the bond has a fixed-rate of interest, the investor will have less purchasing power during inflation. Also, if the interest rates rise, the bond will have a lower market value.

• The risk that there will not be an active bond-buying market and investors cannot get liquidity with their bonds. 

Municipal bonds may be an attractive investment for people looking for tax advantages. People in the 25 percent income bracket or higher are the best investors for municipal bonds. Anyone considering investing in municipal bonds is recommended to consult a free tax calculator or a tax professional to discuss a particular bond’s tax implications.