Bonds are essentially an I.O.U. from the government or a corporation to their bond holders. You lend the money, and they pay you back with interest. Taxable bond holders seek high yields but less volatility than the stock market. Municipal bond holders seek safety and tax benefits. Your investment portfolio could benefit from holding either, or both, type of bonds.
Municipal Bond Basics
State and local governments issue municipal bonds. Investors seeking tax shelters love municipals, affectionately nicknamed muni bonds or munis. Munis often fund special projects, like construction of schools, bridges and prisons. A few times per year most muni bonds make regular, fixed payments called coupons. There are also zero coupon bonds, which are sold at a deep discount from their face value. Zero coupon bonds pay no interest along the way, but at maturity you get back the full face value.
Municipal Bond Advantages
Municipal bonds historically have a low rate of default because they are backed by the government. They are seen as a relatively safe investment. Many state constitutions prioritize debt service over most other financial obligations, which contributes to the low default risk. Beware that defaults, though rare, are still possible. Bonds are also not immune to price declines. It is their tax free status, however, that gives them such a favorable place in so many portfolios. Most munis are state and local tax free to residents of their state of issuance. Others are also exempt from federal income tax, making them “double tax free.”
Taxable Bond Basics
Taxable bonds are usually corporate. Periodic interest payments are made, and they return the entire principal upon maturity. They offer no tax benefits, but they usually pay higher interest than municipals. Corporate bonds always bring default risk, putting your principal in jeopardy. You can research their riskiness by checking their credit rating with Standard & Poor's or Moody's credit agencies. Bond mutual funds leave the research to the fund managers, and you may prefer them to buying individual bonds since they also bring diversification. Taxable municipal bonds exist as well, and though they offer no tax benefits they do offer higher yields and government backing.
The Price and Interest Relationship
Bond prices and interest rates have an inverse relationship. When one rises, the other falls. If you plan to trade bonds rather than holding them to maturity, you need to keep interest rate vs. bond price fact in mind. Most financial advisers recommend “laddering” bonds, which means buying bonds with different maturity dates. A mix of long and short term bonds can protect yourself from the rise and fall of interest rates and their impact on bond prices. If you invest in bond mutual funds, be aware that since the funds actively trade their share prices fluctuate.
When comparing taxable bond and municipal bond yields you can't simply look at their interest rates. You must look at the tax-equivalent yield for the muni bond. The higher your tax bracket, the more valuable the tax exemption, which is why munis are so popular with high net worth individuals. An investment adviser or accountant can help you determine the yield by plugging in your tax rate, or you can use an online calculator. The tax-equivalent yield is higher for residents of states with high state income tax rates.
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