Municipal bond issued by South Carolina in the 19th century.
Source: Wikimedia Commons.
Most investors focus on the stock market because of the huge
potential returns stocks can produce in your portfolio. By
contrast, bonds tend to be far more conservative, with fewer
growth prospects and limited upside. But the bond market is every
bit as complex as the stock market, and knowing the ins and outs
of various types of bonds can be useful in improving the returns
of a diversified portfolio. Among the more interesting kinds of
fixed-income securities are municipal bonds, which have some
peculiar traits you won't find in any other type of asset. Let's
take a closer look at municipal bonds and how they can play a
useful role in your investing.
What are municipal bonds?
Municipal bonds are debt obligations that are issued by state
and local government entities. As with other bonds, the issuer
sells bonds to investors, taking the proceeds and using them
toward whatever purpose that particular government body serves.
In exchange, investors receive interest payments, usually twice a
year, at an interest rate that's fixed at the time of issuance.
Each municipal bond also has a maturity date on which the
government entity promises to return the invested principal to
Louisiana municipal bonds. Source: Wikimedia Commons.
Municipal bonds have a reputation for being safe investments.
Because most government bodies have the power to impose taxes on
their constituencies, default rates on municipal bonds tend to be
lower than those of corporate bonds. Yet because state and local
governments don't have the power to create money, municipal bonds
aren't as safe as Treasury bonds, which are backed by the full
faith and credit of the U.S. Treasury.
What is the history of municipal bonds?
Municipal bonds have been used by government entities to
finance public projects for centuries. In the U.S., the use of
municipal bonds has generally paralleled the growth trajectory of
the domestic economy, with municipal bonds helping finance the
massive infrastructure improvements that took place in the late
19th century and early 20th century.
A big upswing in popularity of municipal bonds occurred with
the institution of the federal income tax about 100 years ago.
Unlike almost every other type of investment, the interest income
on municipal bonds is generally exempt from federal income
taxation, meaning that the yield on municipal bonds represents an
after-tax return rather than a pre-tax return. In addition,
municipal bonds issued by a particular state or city generally
pay interest that is also exempt from state and local income
taxes imposed by that issuing government entity. As a result,
municipal bonds in areas like New York City can end up being
triple-tax-free, giving investors a huge tax benefit compared to
How big is the municipal bond market?
According to statistics from the Municipal Securities
Rulemaking Board, the municipal bond market is composed of about
$3.7 trillion in bonds. That figure has grown by about 10 times
since 1981, and from less than $20 billion back in 1945.
The Securities and Exchange Commission estimates that there
are almost 44,000 state and local issuers of municipal bonds.
With each issuer typically offering multiple bond issues to
investors, those seeking to buy municipal bonds can choose from
hundreds of thousands, or even millions, of different securities.
That variety gives investors the ability to customize their
municipal bond portfolios to give them the exact exposure to
credit risk, maturity needs, and interest rates that they
Why invest in municipal bonds?
The tax-free nature of municipal bond interest is their
biggest appeal and leads many investors to seek out municipal
bonds for their portfolios. As you'd expect, municipal bonds
typically have lower yields than taxable bonds, as the market
takes the tax benefits of municipal bonds into account when
setting prices. But over the past several years, the impact of
Federal Reserve bond purchases has created unusual conditions in
the bond market, and currently, 30-year municipal bonds have an
almost identical yield to 30-year Treasury bonds. Given that
Treasuries are subject to federal taxes, that situation is
extremely unusual and provides a huge after-tax yield advantage
for investors -- especially those in top tax brackets.
Possible use of municipal bonds for funding solar power projects.
Source: National Renewable Energy Laboratory.
Yet municipal bonds aren't without risk. During the financial
crisis, many municipalities suffered huge drops in tax revenue
due to plunging property values, which put municipal bond
repayment at risk. Several municipalities -- most notably the
city of Detroit -- have had to file bankruptcy or seek other
forms of protection from creditors, and that has left municipal
bondholders with uncertain returns on their investments. Even now
that conditions in the credit markets have generally improved,
investors aren't entirely satisfied that the municipal bond
market is as reliable or safe as the Treasury bond market.
For investors looking to maximize their after-tax returns,
municipal bonds can be an especially useful tool in minimizing
taxes on investment income while still getting reasonable
returns. As is the case across the broader bond market, municipal
bond yields aren't all that high right now. But given time, if
the Fed starts raising rates as predicted, then municipal bonds
could look a lot more attractive in the years to come.
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Municipal Bonds: Investing Essentials
originally appeared on Fool.com.
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