Nobody likes to pay taxes. That’s why investors naturally are interested in earning tax-free income. Municipal bond issues are a popular way to earn federal tax-free income.
Municipal bonds (also known as “munis”) are fixed-income investments that may provide higher after-tax returns than similar taxable corporate or government issues. In general, the interest paid on municipal issues is exempt from federal taxes and sometimes state and local taxes.
A municipal bond is an interest-bearing debt obligation issued by a state or local municipality, which may support general government needs or fund a public works project. A municipal bond can also be issued by legal entities such as a housing authority or a port authority. A variety of projects, such as new roads, stadiums, bridges, or hospitals, are usually financed by issuing municipal bonds. In addition to providing tax-exempt interest, municipals can be an excellent way to invest in the growth and development of your community.
Municipal bonds are different from corporate bonds in several ways. Most importantly, the income munis generate is usually exempt from federal taxes, whereas the income generated by corporate bonds is fully taxable. In addition, if the investor lives in the state that issued the bond, the state tax is usually exempted. Local taxes (if any) may also be exempted. If the municipal bond is a “private purpose” bond, the interest is taxable unless specifically exempted. Also, income from some bonds may be taxable under alternative minimum tax rules. Their general tax exemption sets municipal bonds apart from other bonds, often referred to as “tax-exempt bonds.”
However, there is a category of municipal bonds that can be fully taxable. They are usually used by municipalities to finance projects that do not directly benefit the general public and may be used to finance the shortfalls of the state and local pension funds.
The most common type of municipal is called the general obligation (GO) bond. These bonds are not tied to a particular community project, and the issuer of the GO bond is obligated to make interest and principal payments on time. Depending on their credit rating, this can make them one of the more credit worthy municipal investments.
Another type of bond is the revenue bond, which is backed only by the revenue to be generated by the project. Other types include special tax bonds and industrial revenue bonds,
and variations on the general obligation bond. Major types of municipal bonds
Secured only by a specified revenue source such as highway tolls or airport fees. Depending on their credit rating, they can be considered somewhat riskier than general obligation bonds and thus offer higher yields.
Backed by the full faith and credit of the issuing government and its taxing power. They can be considered very low risk, depending on the credit rating and thus offer the lowest yields. They are approved by voters.
Short-term debt issued by governments to meet cash-management needs, budget shortfalls, and the like. Typically they are backed by a bank letter of credit and carry maturities of less than nine months. The yields offered are generally low due to their short maturities.
Municipalities bonds are issued for many reasons including specific projects and funding for day to day government needs. An investor buying a muni bond is possibly funding for a particular project over a set period of time. They expect to receive interest or coupon payments (usually semiannually) and the initial principal back when the bond matures.
Professional management may save you the hassle of researching and evaluating the thousands of individual bonds on the market. In addition, individual municipal bonds are denominated in increments of $5,000.00 face amounts, which will result in a total purchase of more or less than $5,000.00. Municipal bonds and the mutual that invest in them continue to offer many investors higher after-tax yields than could be earned on comparable taxable investments.
As with the prices of other types of bonds, municipal bond prices react to changes in interest rates.
Bonds are subject to credit, and market interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
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