Investing In The Municipal Bond Market

Municipal bonds (also known as munis) are considered one of the safest types of investments, and their tax-exempt status is a strong attraction for many investors. A municipal bond is essentially an IOU from your local government for funds used to finance community projects and developments. An investor who purchases a bond will receive periodic fixed-interest rate payments (often referred to as the yield) on the principal, which are exempt from federal, and often state and local, taxes. This occurs until the bond has reached its maturity date, when the principal is immediately paid back in full by the issuing agency.

There are two types of municipal bonds, General Obligation bonds and Revenue bonds, which differ in the type of government entity issuing the bond. General Obligation bonds usually support local goverment projects such as highway repair and hospital construction, and are supported by taxes. Revenue bonds are typically issued by utility or construction companies to fund infrastructural development, and are paid with a percentage of the income generated from the project.

Advantages and Risks

The primary advantage of investing in municipal bonds as opposed to taxable bonds is their tax-exempt status. However, the yield rates are generally lower than those of taxable bonds. To compare the overall yield of a tax-free municipal bond with a taxable bond, you can use the following formula to account for this difference:

Tax-equivalent yield = (tax-exempt yield) / (1 – (tax bracket)).

For example, an investor in the 15% tax bracket considering a 5.2% yield municipal bond would have a (5.2)/(1 – .15) = 5.2/0.85 = 6.1% taxable equivalent yield, while an investor in the 30% tax bracket would have a (5.2)/(1 – .20) = 5.2/0.7 = 7.4% taxable equivalent. For this reason, municipal bond investment is generally more attractive to investors in higher tax brackets.

The risks inherent in municipal bonds are very low if you choose a bond with a high credit rating (bonds rated BBB or higher are generally considered to be safe investments) and hold onto the loan until it matures. The normal market risk factors will apply if you decide to sell your bond before maturity, depending on how interest rates have changed since your purchase of the bond.

How to Invest

As with any investment, you should consult an investment professional to consider investment strategies suited to your income and expectations. The most common strategy for municipal bond is to find one or more safe, high-yield bonds and hold them until they mature. A more sophisticated strategy is to create a bond ladder, which diversifies bond holdings and maturity dates to reduce overall risk.

Sources: http://www.investopedia.com/, http://beginnersinvest.about.com/

Karl Wallullis is a guest blogger for My Dog Ate My Blog and a writer on online schools for Guide to Online Schools.