What Are Municipal Bonds?

Feb 13, 2024 By Triston Martin

If your main investment objective is to save capital and generate a tax-free income stream, a municipal bond is worth looking into. Municipal bonds are issued by government agencies. When you purchase a municipal bond, you lend money to a municipal bond issuer. The interest payments are set over a period of time. The bond matures at the end of the predetermined period, and you receive the entire amount of your original investment.


Types of Municipal Bonds


General Obligation Bonds


General Obligation Bonds, a type of munis, are bonds for which the issuers guarantee repayment by all means necessary. This means that issuers can use their tax power to increase revenue to repay the bond in any circumstance. If an issuer has trouble paying back its bonds, the institution will have to raise taxes to get the required revenue. States, cities, and towns most commonly issue G.O. The most common issuers of G.O. bonds are states, towns, cities, and school districts. These bonds rely on local municipalities to guarantee payment.


Revenue Bonds


Revenue bonds are a type of muni repaid with the proceeds from projects the bonds have helped to fund. Revenue bonds have a higher risk of an issuer defaulting on the bond. Investors should be aware of this fact. These bonds are issued by institutions that can do everything they need to raise revenue, but this may not always produce the required revenues. If a transportation authority issues a municipal bond with financing the construction of a toll road, revenue from the tolls could be used to repay the bonds. If the issuer has problems paying the bonds back, it might raise the toll prices to increase revenue. This does not guarantee higher revenue as drivers may switch to roads that aren't toll. Investors should know that the ability to repay these revenue-based bonds can vary between institutions.


Working


A municipal bond is a type of debt a municipality or state issues to finance public works. Investors lend money to the issuer, just like other bonds. The issuer promises to pay investors interest twice a year and return the principal when the bond matures. If you put $5,000 into a municipal bond with 4% interest for ten years, that's $5,000 you have borrowed. The municipality will return your $5,000 at maturity after paying you $200 in interest each year, usually in biannual installments.


Because bonds are more stable than stocks, they are often more stable than stocks. To calculate the value of a bond, you add the face value to the interest it will pay. The interest rate is the main factor that determines a bond's value. A bond with a higher interest rate is more valuable than one that is new, which is why new bonds are available for sale. Conversely, a bond with a lower rate is less valuable than one that is new. This is because the current yields affect the price you can sell or buy the bond.



Rates For Municipal Bonds


Three major rating agencies rank bond issuers based on their ability to meet financial obligations and not default on them. These are S&P Global, Moody's (NYSE: MCO), and Fitch. Bonds' interest rate is generally lower if an issuer has a higher credit rating. To offset the risk associated with a lower rating, issuers with higher credit ratings must offer higher interest rates. However, bond ratings are subject to change. A strong rating does not mean an issuer can't be downgraded if it has financial difficulties. Muni bonds can recover a high percentage even if they fail, but you can keep your capital up for longer than the term, and investors seldom recoup the interest not paid. When choosing which municipal bonds you should buy, consider all implications.


Should You Consider Investing in Municipal Bonds?


This question will depend on your financial goals and your situation. As with all bonds, the main reason to own them, as with all other bonds, is that they have a lower risk of losing capital for higher potential total returns. This is especially true for funds with the lowest risk of permanent loss or is part of a portfolio that includes stocks and bonds. Consider muni bonds when comparing them to corporate bonds. Don't forget about the benefits, such as historically lower losses and possible tax benefits that could lead to higher after-tax yields.


Call Risk



Many bonds permit the bond issuer to refund all or part of it before the maturity date. The investor receives his capital back with a premium in exchange for early debt retirement. Your income stream would end sooner than expected, even though you receive your initial investment and come back if the bond was called.

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