Municipal bonds are debt securities issued by government entities to raise capital for projects within that municipality.
Municipalities include states, counties, cities, townships, school districts, hospitals, public works, highways, forestry divisions and other public governing bodies. Investors are essentially lending capital to the municipality, which guarantees making interest payments (usually semi-annually) and returning the principal at maturity.
Municipal bonds are assigned credit ratings by large agencies such as Moody's, Standard & Poor's (S&P) and Finch. As with most fixed-income securities, for a bond to make investment grade, it must have a rating of Baa from Moody's, a BBB from S&P or a BBB from Finch.
Types of municipal bonds include:
Insured Municipal Bonds
Interest and principal payments are guaranteed by a third-party insurance company.
Zero Coupon Bonds
Zero coupon bonds are sold at a considerable discount from par and receive no intermittent interest payments. Investors receive the par value of the bond at maturity. This is a complimentary investment vehicle for those investors who are looking for a long-term product without periodic payments.
These types of bonds have variable interest rates that are adjusted periodically according to the pre-determined index with which they are associated. Some are indexed from short-term Treasuries and other money markets. Yields are typically lower than other fixed-income products with the same maturity because they offer protection against increased interest rates. These are suitable investments during periods of rising interest rates.
Investors have the right to call the bond before its maturity date. You can 'put' the bond back to the issuer for the par value plus accrued interest at pre-determined intervals at your discretion. Put bonds usually yield lower rates than a comparable bond; however, you can regain your principal and reinvest in higher-yield bonds when interest rates rise.
Investor yield payments are secured by income collected through the use of rentals, charges and tolls. These bonds are issued by special public authorities and they finance bridges, tunnels, airports, hospitals, highways, toll roads, transportation and waterworks projects.
Many investors consider municipal bonds to be one of the safest investment products with regards to interest and principal payments. Historically, they have been known to be a reliable source for meeting debt obligations.
Public disclosure statements of financial conditions are updated periodically and are readily available.
Interest from many municipal bonds is exempt from both federal and state taxes.
A vast array of offerings is available to meet your particular portfolio in terms of maturities, investment quality and types of instruments. Issues are offered in $5,000 denominations for both short-term notes and long-term bonds.
An active secondary market is available and expanding. The amount of state and local governments’ debt that was outstanding at the end of 2009 was $2.4 trillion.1
Some municipal bonds are not tax-exempt from state and local taxation.2 Resident investors investing in municipal bonds within their state often are tax-exempt from income interest paid at the state and local level, as well as at the federal level.
Federal taxation is applied to municipal bonds that do not significantly benefit the general populous. They include public projects, such as underfunded pension plans and sporting facilities.
1 - Russek, Frank. "The Underfunding of State and Local Pension Plans." Congressional Budget Office. Congressional Budget Office, May 2011. Web. 1 Oct. 2015.
2 - Alternative Minimum Tax (AMT) requires certain investors to pay tax on interest income from municipal bonds.