How Municipal Bonds Work

The two most common types of municipal bonds are general obligation and revenue bonds. Both are exempt from federal, state and local taxes -- as long as you live in the issuing municipality. What's more, they're longer-term bonds, which take anywhere from one to 38 years to mature.

 

General obligation bonds are bonds that are backed by the taxing power of the issuing municipality [source: Securities Industry and Financial Markets Association]. The municipality will pay back interest and principal to all investors through normal taxes or specific bond issues that are approved by voters.

 

Revenue bonds, on the other hand, are paid back through funds generated by the project itself. For example, revenue bonds can be sold to fund the construction of a toll bridge. Bond investors are paid back through the tolls generated by the completed bridge. Sometimes a state or local government will create a special bond authority to oversee revenue bond-funded projects like toll roads and bridges, airports and low-income housing [source: Securities Industry and Financial Markets Association].

Almost half of municipal bonds are insured. An insurance company buys the bonds and resells them to investors. Insured municipal bonds carry a guarantee that even if the original bond issuer defaults, the insurance company will keep paying interest for the life of the bond, plus the principal at the maturity date. Insured bonds generally carry a lower interest rate than uninsured bonds for two reasons: the issuer has to pay a premium for the insurance coverage and the bond is considered less risky, even for an investment that's inherently very safe [source: Morningstar].

Municipal bonds don't always have a fixed rate. Floating rate or variable rate bonds are long-term securities with interest rates that reset daily, weekly or monthly [source: Van Scoy]. Whether the interest rate goes up or down depends on prevailing market conditions. Floating rate municipal bonds are attractive for long-term investors who are looking to keep up with the yields of shorter-term investment notes. They can be bought and sold on short notice without the threat of losing principal.

Similar to floating rate municipal bonds is something called a put bond. An investor can sell it back to the issuer at a specified date before the bond matures. The value of the bond at the put date is agreed upon when the bond is originally purchased. This type is attractive because it offers several maturity dates with guaranteed yields for each date.

Zero coupon municipal bonds are securities that don't pay any interest until the bond matures. So instead of receiving interest payments twice a year for the life of the bond, you receive one lump sum -- interest plus principal -- on the maturity date. A person with a long-term savings goal like retirement or paying for a child's college education may be interested in a zero coupon bond [source: Securities Industry and Financial Markets Association].

The last type of municipal bond is a taxable municipal bond. Taxable municipal bonds exist because the federal government doesn't finance certain types of projects that don't have a clear benefit to the public, like local sports facilities or the funding of a faltering city pension plan [source: Securities Industry and Financial Markets Association]. Taxable bonds carry higher interest rates to offset the loss to income taxes.

So what are the some of the major advantages and disadvantages of investing in municipal bonds? Read on to find out why someone would choose such a low-interest security as opposed to the relatively higher yields offered by Treasury bills or CDs.

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The greatest advantage of municipal bonds can be summed up in two words: tax free. The interest rates on municipal bonds may seem low compared to similar long-term securities like Treasury bills and CDs, but tax advantages may level the playing field. Let's look at some examples.

If you're in the 25 percent bracket for 2008 federal income taxes, you'd have to find a taxable security with an interest rate of 4 percent to equal the yield of a tax-free municipal bond with an interest rate of 3 percent [source: David Lerner]. In other words, if you have $5,000 to invest in a bond, you'd earn the same with a 3-percent tax-free bond as a 4-percent taxable bond.

The difference between taxable and tax-free bonds becomes even more exaggerated as you climb to higher income tax brackets. If you find yourself in the 35 percent federal income tax bracket, you'd have to find a 4.62 percent taxable interest rate to yield the same amount as a humble 3 percent municipal bond [source: David Lerner]. Some taxpayers also have to pay state and local income taxes, depending on where they reside. In this case, a triple tax-free municipal bond -- exempt from federal, state and local taxes -- is highly attractive.

The second major advantage of municipal bonds is that they're incredibly safe. Between 1970 and 2000, the 10-year cumulative default rate for municipal bonds was 0.04 percent [source: Fahim]. In other words, during those 30 years, less than half of one percent of municipal bonds failed to pay back the promised interest and principle. Compare that to corporate bonds -- bonds issued by private companies and investment firms to finance business operations -- which carried a default rate of 9.83 percent over that same period [source: Fahim]. Insured municipal bonds are practically risk-free, since the insurance company will pay up even if the bond issuer defaults.

You can find a tax-free bond that fits your investment strategy. Put bonds allow you to cash in earlier than the maturity rate with no penalties. Floating-rate municipal bonds allow riskier investors to adjust for fluctuating markets, and zero coupon bonds are ideal for risk-free long-term investments.

Since municipal bonds pay interest twice a year, they can also supply a predictable, tax-free income stream for retirees. Even if you sell a municipal bond before its maturity date, you'll receive the current market price of the bond -- which may be more or less than the original price -- without any additional penalties.

The only real disadvantage of municipal bonds is that they carry relatively low interest rates compared to other types of securities. This is particularly true when the economy is strong and interest rates for Treasury bills and CDs rise. Even after adjusting for taxes, it's often hard for municipal bonds to keep up with the competition. But in economic downturns, all bond rates are low, so the tax-free status makes a bigger difference.

Another less common complaint about municipal bonds is that they can be difficult to cash in if the issuer is a smaller municipality like a rural county government.

Let's learn how to buy municipal bonds and how much room they should take up in an investment portfolio.

In the United States, there are more than 50,000 states, cities, counties and other local entities that issue a total of more than 2 million different municipal bonds [source: Securities Industry and Financial Markets Association]. You can track the prices and interest rates of the best-known municipal bonds in the finance section of any major U.S. newspaper.

Municipal bonds can be purchased through an investment broker. Some brokers specialize in bonds, but any stockbroker can make the purchases as well. Transaction fees for buying a municipal bond through a broker are typically between 0.5 percent and 3 percent of the purchasing price. To compare, commissions on stock purchases run between 1 percent and 4 percent [source: Securities Industry and Financial Markets Association]. The minimum price for a municipal bond is almost always $5,000 and goes up in increments of $5,000.

A municipal bond is really a loan. You're loaning the municipality money, and the municipality promises to pay you back according to the terms of the loan. Here are the most common terms associated with a municipal bond:

The next most important thing to consider when buying a municipal bond is its bond rating. Moody's Investors Services and Standard & Poor's Corporation offer assessments of every municipal bond on the market. Both companies use a letter system to rate the relative security of investing in a municipal bond. With Moody's, Aaa is the highest rating, while S&P uses AAA. Everything above BB is considered a fairly secure investment, while anything below is considered speculative. Bonds with a C rating may already be in default.

Municipal bonds are an important component of any investment portfolio. Your stage of life determines how many you should own. Younger people generally invest in higher-risk, higher-yield securities like stocks. Tax-free municipal bonds will comprise a more significant chunk of an investment portfolio as you get older and enter higher tax brackets.

If you already invest in a mutual fund, then you probably own some municipal bonds. Mutual fund managers use low-risk municipal bonds to balance higher-risk investments in the portfolio. Another strategy is to invest in special mutual funds that only buy municipal bonds. You can employ an investment strategy called a bond ladder, in which you buy several different bonds with staggered maturity dates. As each bond matures, you invest the principal in the next bond, keeping a steady flow of interest income.

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