What are Municipal Bonds?
Municipal bonds or Munis are simply the debt securities that are issued by the states, cities or the counties and are aimed to fund the day-to-day projects or even to finance the capital projects such as building the schools etc.
By purchasing the municipal bonds, it means that you are lending money to the bond issuer and in exchange, you get a promise for a regular interest payment which in most cases happens in semi-annual basis and the return of the principal.
How do the Munis work?
Before we get into the details of how the municipal bonds work, you have to understand that these types of bonds are tax-free. They are one of the safest long-term investments and since they are securities, it means that the original owner can sell them to other investors on a secondary market.
The price of the municipal bond over time may change but the interest rate will never change, more interesting is that the Munis market is over 3.5 trillion and 60% of the total value is the general bond, on the other hand, almost revenue bond.
The municipal bonds work best for the investors who need a tax-free revenue and as a result, they have a slightly lower interest rate than the taxable bonds. What’s even interesting is that you can buy them directly from a registered municipal bond seller and you can also own them indirectly through a bond fund. When the bond maturity date is due the holders of the bond expect to be paid back their principal amount.
To really entice the investors to lend the amount, the issuer pays off the interest on the bond. The state tries to exempt the interests from the taxes. The issuer will pay the interest every 6 months until the bond matures. Use this calculator to determine the yield required by a fully taxable bond to earn the same after-tax income as a municipal bond.
Features of a Municipal Bond
A typical municipal bond will yield higher returns than the government bonds. In many cases, the municipal bonds are also insured by the bond insurance companies and therefore, this provides another level of the much-needed protection to the investors. Lastly, municipal bonds offer a vast array of offers which are available to meet your particulate portfolio in consideration to the maturities, the quality of investment and also the types of instruments.
You have to also keep in mind that the bonds will usually come with a coupon. This is the original sense was just a detachable part of the bond that the holders used to collect the interest. Today, a coupon could mean anything and mostly, to denote the annual interest rate paid on the bond.
The YTM of a Municipal Bond
This is one important consideration to make, the yield-to-maturity which is the calculation of the total interest plus the principal amount that would amount to if the investor decides to keep the investment to maturity.
Types of Municipal Bonds
What follows is a brief categorization of the municipal bonds and also the revenue source for their coupon payments.
- The general obligation (GO) – these are the bonds which are backed up by the creditworthiness of the issuer. Majorly, the voter approval is the prerequisite for the issue of the bond. They are the safest and as a result, they tend to yield a much lower yield.
- The revenue bonds – these, on the other hand, are the bonds which interest payments are secured with a certain type of a revenue stream. The yields for these bonds are higher because of their nature, they are much riskier than the general obligations.
- Assessment bonds – which are special in the sense that they offer their repayment which majorly comes from directly from taxes
Before investing, investors are required to do some preliminary background check on the state or the agency issuing the bond as the returns from the bond will largely depend on the municipality offering the bond.
Advantages of Investing in Municipal Bonds
Municipal bonds are free from the taxes
Unlike so many other investment vehicles, the municipal bonds are free from the federal taxing. No one would like to hand over big chunks of money to the tax people and therefore, if you prefer an investment that you do not have to pay for the taxes, then the Munis are the best option that you have.
If you are in a high tax bracket, then the Munis will be a better investment for you. More to that, the municipal bonds may just be the thing that you need to annex your traditional 401K or IRA investments.
Tax-advantaged compound growth
Another advantage of the municipal bonds is that they shelter your investment accounts from the taxes and thus allowing growth which compound more quickly as compared to the taxable accounts. Assuming that you purchase the Munis through the mutual fund, this means that you have a chance to reinvest the bond income which will result in a compound growth.
Compared to the stocks, Municipal bonds presents a low volatility. Historically, the municipal bonds are known to offer the safest form of investment while adding an extension of the exemption to the taxes returns and generally, you will also find that the Municipal bonds offer a much better result on the invested capital than the FDIC insured accounts.
Higher level of liquidity
What makes the municipal bonds a good quality for most people is the fact that they are highly liquid and are traded on a secondary market. This, therefore, means that if you need money quickly may be for an emergency, you can quickly access the money without incurring a dime as a tax penalty.
Buying Municipal Bonds
So, you’ve made that decision, to finally invest in the mutual funds, that may be the safest and most prudent decision you may have made. Theoretically speaking, there are 2 main ways that you can invest in the municipal bonds;
1. Through the municipal bond funds (direct method). Here, the investor has the option of purchasing the bonds directly from the municipality through the intermediaries, in this case, a bank or a broker, just like the stocks. This method offers the investors with the confidence and comfort knowing what bond they own within their investment portfolio.
2. The other way is to invest in the bond is through purchasing the municipal bond fund. This method offers the investors with an instant diversification across an assortment of municipal bonds. The main advantage of this method is that they offer the investor with the reduced risk. More so, the investor gets an added advantage in that in this option, there is increased liquidity available through the bond funds.
Municipal bonds offer investors with a number of added advantages and the major one is the never-ending pursuit for a tax-free investment. But before making that major purchase, be sure to, first of all, investigate on the particulate bond you want to invest in.