Municipal Bonds

A municipal bond or municipal bond fund is suitable for an investor that wants income that is free from federal income tax. This is not an acceptable investment for a tax deferred account like a Traditional or Roth IRA. The information in presented in 4 sections: issuers, holders (investors), taxes, and risk.

Municipal bond issuers

Municipal bonds are issued by states, cities, and counties, or their agencies (the municipal issuer) to raise funds. The methods and traces of issuing debt are governed by an extensive system of laws and regulations, which vary by state. Bonds bear interest at either a fixed or variable rate of interest, which can be subject to a cap known as the maximum legal limit. The issuer of a municipal bond receives a cash payment at the time of issuance in exchange for a promise to repay the investors who provide the cash payment (the bond holder) over time. Repayment periods can be as short as a few months (although this is rare) to 20, 30, or 40 years, or even longer.

Municipal bond holders

Municipal bond holders may purchase bonds either directly from the issuer at the time of issuance (on the primary market), or from other bond holders at some time after issuance (on the secondary market). In exchange for an upfront investment of capital, the bond holder receives payments over time composed of interest on the invested principal, and a return of the invested principal itself. Repayment schedules differ with the type of bond issued. Municipal bonds typically pay interest semi-annually. Shorter term bonds generally pay interest only until maturity; longer term bonds generally are amortized through annual principal payments. Longer and shorter term bonds are often combined together in a single issue that requires the issuer to make approximately level annual payments of interest and principal. Certain bonds, known as zero coupon or capital appreciation bonds, accrue interest until maturity at which time both interest and principal become due.

Taxability

One of the primary reasons municipal bonds are considered separately from other types of bonds is their special ability to provide tax-exempt income. Interest paid by the issuer to bond holders is often exempt from all federal taxes, as well as state or local taxes depending on the state in which the issuer is located. The type of project or projects that are funded by a bond affects the taxability of income received on the bonds held by bond holders. Interest earnings on bonds that fund projects that are constructed for the public good are generally exempt from federal income tax, while interest earnings on bonds issued to fund projects partly or wholly benefiting only private parties, sometimes referred to as private activity bonds, may be subject to federal income tax.

Risk

The risk ("security") of a municipal bond is a measure of how likely the issuer is to make all payments, on time and in full, as promised in the agreement between the issuer and bond holder. Different types of bonds are secured by various types of repayment sources, based on the promises made in the bond documents. The probability of repayment as promised is often determined by an independent reviewer, or "rating agency". The three main rating agencies for municipal bonds in the United States are Standard & Poor's, Moody's, and Fitch. These agencies can be hired by the issuer to assign a bond rating, which is valuable information to potential bond holders that helps sell bonds on the primary market.

The only risk is default risk with the issuer being unable to repay the full amount. Bonds issued by California with budget problems, and other states with high unemployment, should be avoided. You can reduce this risk by investing in a mutual fund rather than an individual bond.