Municipal bonds, or muni bonds, are debt instruments issued by city or town governments that need to raise money for various projects. The chief risk of muni bonds is that the issuer could default on interest or principal payments, so muni bonds are only as good as the financial strength of the cities and towns that issue them. While investors are often wary of muni-bond investing, betting on this market makes sense for several reasons.
Predictions for doom and gloom in this market segment can be overstated or simply wrong. Financial analyst Meredith Whitney earned the dubious distinction of wrongly forecasting that muni-bond issuers would default on at least $100 billion worth of debt in 2011, according to a 2012 CNBC article. The low end of her prediction called for 50 municipal bankruptcies in that year, when fewer than 30 bond issuers actually became insolvent in 2011.
Historically, investors don't have to pay federal -- and in some cases local -- taxes on the interest earned from muni bonds. This special treatment is dependent on public policy and can change if new tax laws pursue this revenue source. For lawmakers to rescind the tax breaks that muni bonds present, they would have to be willing to accept that their actions would likely cause investors to require higher interest payments, which would ultimately increase the cost for cities and towns to borrow money, according to a 2012 "New York Times" article.
The muni bond market is a place where higher-than-average returns are common. Traditional government bonds are likely to do a successful job at protecting your money, but they typically won't promise you high returns. If you're willing to take some risks, municipal bonds can produce returns of anywhere from 3 percent to 15 percent, while government-issued Treasury bonds are yielding as little as 1 percent in 2012, according to a 2012 ABC News article.
Credit Quality and Dependability
Muni bonds are rated by professional analysts, who grade them by their creditworthiness. If a particular grade reflects too much risk, you can simply avoid that muni bond in favor of one with better credit quality. Even if you are looking for the most sizable returns and are willing to invest in riskier muni bonds, you still have a pretty good chance to make money. Not even 1 percent of muni bond issuers default every year, according to a 2012 "Kiplinger" article. In the event of default, a bond issuer can reorganize the debt and continue paying investors.
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