Tax-exempt municipal bonds offer a wide range of benefits, including tax-free income, safety, predictable cash flow, diversification and liquidity. Under present federal income tax law, the interest income earned from investing in municipal bonds is exempt from federal income taxes. In most states, interest income from securities issued by governmental entities within the state is also exempt from state and local taxes for residents of that state.
So, how do they work? Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities to raise money for schools, highways, hospitals and sewer systems, as well as many other public projects. There are two basic types of municipal securities:
- General Obligation Bonds. Principal and interest are secured by the full faith and credit of the issuer and usually supported by the issuer’s limited or unlimited taxing power.
- Revenue Bonds. Principal and interest are secured by revenues from tolls, charges or rents paid by users of the facility built with the proceeds of the bond issue. Some examples of projects financed by revenue bonds include airports, toll roads, bridges, water and sewer systems, hospitals, and low-income housing.
When you invest in a municipal bond, you are lending money to an issuer who promises to pay a specified amount of interest, known as the coupon, which is usually paid semiannually. The issuer also promises to return the principal on a specific maturity date.
When purchasing bonds, an investor’s primary concern should be the issuer’s ability to meet its financial obligations. Historically, municipal bonds have been one of the safest investments available, second only to U.S. Treasury obligations. One way to evaluate an issuer is to examine its credit rating. Two of the primary bond rating agencies are Moody’s and Standard and Poor’s. Bond ratings are important because they reflect a professional assessment of the issuer’s ability to repay its debt. The rating symbols of the two agencies are defined as follows:
Credit ratings, however, should not be the sole basis for any investment decision. The ratings cannot, for example, take into account market trends or unforeseen natural disasters.
In addition to their stand-alone creditworthiness, municipal bonds may be insured by outside agencies. These insurers guarantee that they will pay bondholders their principal and interest if the issuer defaults. Some of the larger and more well-known municipal bond insurers are the Municipal Bond Insurance Association (MBIA), American Municipal Bond Assurance Corporation (AMBAC) and Financial Guaranty Insurance Company (FGIC). Insurance does not eliminate market risk.
Investors can diversify their bond holdings by choosing from a wide range of maturity dates, credit quality, geographic locations, issuers and types of bonds. This allows the bondholder to have his or her assets allocated over various sectors of the market. Municipal bond investors may also have the opportunity to invest locally in projects taking place in their own communities.
It is important to understand that during the life of a bond, the market price changes as market conditions change. An investor should understand how the direction of interest rates may affect the value of his or her bond holdings. Prices increase when interest rates decline, and prices decline when interest rates rise as explained below:
- When interest rates fall, new issues come to market with lower yields than older securities, making older securities worth more; therefore the increase in price.
- When interest rates rise, new issues come to market with higher yields than older securities, make the older ones worth less; therefore the decline in price.
If you sell your municipal bonds prior to maturity, you will receive the current market price, which may be more or less than your original cost, and may generate gains or losses.
Municipal bonds may not be right for every investor. To find out if municipal bonds fit into your overall investment strategy, please call your financial advisor. iBi