Municipal bond: Bonds issued by state and local government units. Earnings are tax-free. Often referred to as “munis,” Municipal bonds are debt securities issued by state and local governments, as well as various governmental entities such as cities, counties, school districts, and public utilities. These bonds are used to raise funds for various public projects and initiatives, such as building schools, highways, water treatment plants, and other infrastructure projects.
When you purchase a municipal bond, you are essentially lending money to the issuing government entity. In return for your investment, the government promises to pay you interest at regular intervals (usually semiannually) and return the principal amount when the bond matures.
Key features include:
- Tax Benefits: One of the primary advantages of investing in municipal bonds is their potential tax benefits. The interest income from most municipal bonds is exempt from federal income tax, and in some cases, state and local taxes as well. This makes munis particularly attractive to investors in higher tax brackets.
- Types of Municipal Bonds: There are different types of municipal bonds, including general obligation (GO) bonds and revenue bonds. GO bonds are backed by the full faith and credit of the issuing government, while revenue bonds are backed by the revenue generated from specific projects (e.g., toll roads or airports) and do not necessarily carry the same level of government guarantee.
- Credit Risk: Like any other type of investment, municipal bonds carry risks. The creditworthiness of the issuing government entity is a crucial consideration. Some governments have higher credit ratings, indicating lower risk, while others might have lower ratings, implying higher risk of default. Bond rating agencies assess the creditworthiness of issuers and assign ratings accordingly.
- Yield and Interest Rates: The yield on a municipal bond is determined by its interest rate and its market price. Municipal bond yields are often lower than those of other types of bonds because of the tax advantages they offer.
- Maturity: Municipal bonds have specific maturity dates, ranging from a few months to several decades. Short-term bonds are typically called “notes,” while longer-term bonds are referred to as “bonds.”
- Liquidity: The liquidity of municipal bonds can vary, with bonds issued by larger and more established entities generally being more liquid.
It’s important to carefully consider your investment goals, risk tolerance, and tax situation when investing in municipal bonds. While they can provide tax benefits and a relatively stable source of income, investors should also be aware of the potential risks associated with changes in interest rates, credit quality, and market conditions. FinStream offers free videos that explain Municipal Bonds in more detail.