How Municipal Bonds Work

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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