Municipal bonds and Certificates of Deposit (CD) are good investments for your safe money, but they are very different. You can buy them both from your bank or broker. Municipal bonds generally pay low interest, because they are exempt from income tax, and if your income is not high, you do not have much need for tax exemption and may be better off putting your money into CDs.
Municipal Bond Basics
Municipal bonds represent borrowings by a state or municipality to finance roads, schools, utilities, housing developments and other infrastructure. The interest income from municipal bonds is exempt from federal income tax, and if you live in the state of issue, also exempt from state and local income tax. There are short-term municipal bond investments that trade as money market investments, tax-free money market mutual funds, and longer-term municipal bonds and money market funds made up of municipal bond investments. All these are liquid in the marketplace, meaning they can be easily sold when you want to recover the money you invested. Bonds are subject to interest rate risk, because if market interest rates rise after you purchased your bonds, you will lose money when you go to sell them because their market value has declined.
CDs are issued by banks and finance the bank's lending activities. They are generally considered short-term investments, because they are mostly issued with maturities shorter than two years and can often be redeemed prior to maturity. You may incur an early redemption penalty, but some banks do not charge these penalties, so check before you invest. The interest paid on CDs is subject to federal, state and local income taxes.
Municipal bonds often have either a federal or state guarantee on the timely payment of interest and principal, which traditionally makes them safe investments. This may not always be the case. CDs have a Federal Deposit Insurance Corporation (FDIC) guarantee up to $100,000 per account. This FDIC guarantee has changed from time to time, so it is smart to check before you invest, because if your bank fails, you will only be protected up to the amount of the FDIC insurance limit and will lose any money you have deposited above that limit.
When interest rates are low, there is very little reason to accept the interest rate risk and extended maturity of a municipal bond just for the slight difference the tax exempt feature provides. A CD or a money market mutual fund may be more convenient. On the other hand, when interest rates rise, tax exemption makes municipal bonds particularly attractive. It is wise to consider the credit quality of any municipal bond investments you make as many states and municipalities may be in danger of bankruptcy and there is no assurance the federal government will bail them out. In the case of bankruptcy, you may lose all your investment.
- investment image by Kit Wai Chan from Fotolia.com