Municipal bonds are bonds issued by any municipal organization including cities, counties, states, and school districts. The purpose of these bonds is for general expenditures or to fund specific projects such as highways, new schools, or an athletic stadium. These bonds offer the municipality the opportunity to raise funds without directly raising taxes. Of course, the funds needed to repay the bonds will often come from a tax increase. The main appeal of municipal bonds is that the interest payments are usually exempt from federal taxes. Many municipal bonds are also exempt from state and local taxes in the area they are issued.
However, capital gains that occur when the bond is sold or at the time of maturity (if the bond was bought at a discount) are not exempt from any taxes.
Generally, municipal bonds are considered safer than corporate bonds because a local government is far less likely to go bankrupt than a corporation-however, it has happened in the past, so be aware of the possibility. Because of this safety and the tax benefits, municipal bonds generally have a lower yield than corporate bonds. In order to evaluate the merits of a tax-free bond, you will need to calculate the tax-equivalent yield on the bond. This is the amount of interest a tax-free bond would have to provide to create the same return as a taxable bond. Of course, this calculation will depend on the tax bracket of the individual, but it is an effective way to compare the merits of taxable and tax-free bonds. Investors should also be aware that some municipal bonds are subject to the Alternative Minimum Tax. The bond type which is most often subject to the AMT is one that involves a private and public partnership for something like a sports stadium.
Some municipal bonds can also be insured by outside agencies. These companies will promise to pay the interest and principal if the issuer defaults. Interestingly, both issuers and bondholders can carry this insurance, though a bondholder would need to have a large stake to get the coverage. Another concern about municipal bonds is the secondary market. In many cases the secondary market is very small, meaning it may be very difficult to sell your bond if you no longer wish to hold it. For more details about the risks that face all bonds, including municipal bonds, visit the front page of the Bonds section.
There are two common types of municipal bonds: general obligation and revenue.
These bonds are unsecured municipal bonds that are simply backed by the full faith and credit of the municipality. Generally, these bonds have maturities of at least 10 years and are paid off with funds from taxes or other fees.
These bonds are used to fund projects that will eventually create revenue directly, such as a toll road or lease payments for a new building. The revenues from the projects are used to pay off the bonds. An interesting twist is that in some cases the issuer is not obligated to pay interest unless a certain amount of revenue is generated.
If a municipal bond makes sense for you, you will need to work through a broker in order to purchase them. This is another drawback as you will be forced to pay a commission to the broker before you finally get your hands on the bond. When comparing these bonds to others, remember to take this additional cost into account. In addition, municipal bonds usually come in $5,000 par values and usually require a minimum investment of $25,000 in order to get the best price. So, if you don’t have this amount of money to invest, you may want to look to municipal bond mutual funds to gain access to municipal bonds.