If you are looking for a type of investment that will maintain your capital while getting a tax-exempt income flow, municipal bonds might be a possibility for you. Municipal bonds are debt obligations issued by smaller government entities such as cities or a local school board. Once you purchase a municipal bond, you’re lending money to the issuer in exchange for a fixed amount of interest payments over a set period. Once that period has ended, the bond reached maturity, and the entire amount of your original investment is given back to you.
Municipal bonds come in both taxable and tax-exempt form. The tax-exempt municipal bonds are favored since the incomes they yield are free from federal and, in many instances, state and local income taxes for most investors.
Municipal bonds are available in two forms, General Obligation bonds (GO) and Revenue Bonds.
General obligation bonds are sold to raise immediate capital and are affirmed by the taxing power of the issuer while Revenue bonds, that are created to fund infrastructure projects, are backed by the revenue yielded by those projects. Both types of bonds are tax-free and especially attractive to investors because of the odds that the issuers will repay their debts.
Although purchasing municipals bonds is deemed as a conservative investment strategy, it is not entirely risk-free. The following risks are associated with these bonds:
- Credit Risk – If the issuer is not able to satisfy its financial obligations, it might fail to make regular interest payments and or not capable of paying back the principal upon maturity. Many municipal bonds are supported by insurance, thus securing repayment just in case of a default.
- Interest-Rate Risk – The rate will never change over the life of the bond and if interest rates rise on market, your bonds will be paying a lower rate as compared to the return on the newly issued bonds.
- Tax-Bracket Changes – Municipal bonds yield tax-exempt income, and pay lower interest rates than taxed bonds.
- Call Risk – Many bonds allow the issuer to repay all or a portion of the bond prior to the maturity date.
- Market Risk – The underlying price of a particular bond changes in response to market conditions.
It’s important to note that the risk of a bond issuer is usually considered to increase if the issuer is smaller. Therefore a bond issued by a small city would be considered riskier than a bond issued by a large city. Bonds issued by the US government would be considered the safest type of bonds.