How Municipal Bonds Work

Understanding how municipal bonds work can be tricky.

Understanding how municipal bonds work can be tricky.

If you're just getting started in the investment world, understanding bonds can be difficult. On a basic level, all bonds are loans: whether the issuer is a bank, a corporation or the government, when you invest in bonds you are supporting the issuer's initiatives in exchange for interest payments. Municipal bonds, issued by local governments and groups, are favored by many because it's a way to earn money while supporting new roads, stadiums and other improvements to your community.

Definition

Municipal bonds, often called “munis,” are issued by states or local municipalities to help pay for government or public works projects such as new roads, hospitals, bridges or stadiums. When you purchase a municipal bond, you are essentially loaning money to your local government in exchange for interest payments you will receive. Munis are usually offered in principal amounts of $5,000. When you purchase a bond, you can choose from long-term or short-term investments, each of which comes with a fixed “maturity date” when you will receive payment.

Benefits

Bonds are fixed income investments -- you agree to hold the bond for a fixed period and receive fixed interest payments. The income municipal bonds generate is exempt from federal taxes. If you live in the state where your municipal bond was issued, the bond earnings may also be exempt from state income taxes. Depending on which tax bracket you fall into, municipal bonds have the potential to provide higher returns than taxable corporate or government-issued bonds. Some people see the purchase of municipal bonds as a way to help their community while earning extra income.

Types

There are four main types of municipal bonds. General Obligation Bonds, known as GOs, are one of the least risky types of municipal bonds, because their returns are not linked to a specific government project. The issuer of these bonds is required to make interest and principal payments on time. Because they are low-risk, they also offer the lowest returns. Revenue bonds are slightly riskier than GOs, because returns are based on the expected revenue generated by a particular project, such as tolls for new highways. Commercial Paper munis are used to repay short-term debt incurred by governments. Their maturities are short, usually less than nine months, so their returns are usually low. The last and riskiest kind of municipal bond is the Private Activity Bond. These are used to fund private pursuits and often generate higher yields than the other types.

Disadvantages and Risks

Bonds are not risk-free. Although their lifetime and interest payments are fixed, this does not mean that their returns are fixed. Like all other bond types, municipal bond prices (and thus your returns) change depending on interest rate fluctuations. As interest rates increase, bond prices decrease, and vice versa. In other words, if you buy a bond that is paying 5 percent interest and interest rates rise 2 percent, the price of the bond itself falls, resulting in only a three percent gain. Prices and returns of bonds with shorter times to maturity are affected less by changing interest rates; long-term issued bonds tend to be affected more as rates change over time. Because there are thousands of municipal bonds issued, it is more difficult to keep track of prices in the newspaper or on television. You will need to work closely with a bond dealer to keep up on bond prices.

 

About the Author

Megan Martin has more than 10 years of experience writing for trade publications and corporate newsletters as well as literary journals. She holds a Bachelor of Arts from the University of Iowa and a Master of Fine Arts in writing from The School of the Art Institute of Chicago.

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