Municipal Bonds Tutorial

You need a broker to buy and sell municipal bonds. A broker will be able to search for the right bond for you by the "coupon" (interest rate) it pays and by its maturity date, when the bond expires and the investor gets his money back. Brokers charge a commission of up to 5 percent to carry out the transaction. If you want to avoid a broker, you can just buy into a municipal bond mutual fund. A bond fund pools money from multiple investors and pays out interest and capital gains on trades. "No-load" funds don't charge commissions to buy in, but all funds charge management and marketing fees.

Backed by the laws on debt and bankruptcy, municipal bonds are supposed to be safe, but "safe" is a relative term in the investment world. Some municipalities are flush; some others are just about broke. Bond ratings issued by agencies such as Moody's and Standard & Poor's are supposed to rate these bonds by how safe they are and the likelihood that an investor will be paid all the interest due. The basic division in the rating scale comes down to "investment grade" bonds, which are good for a reliable stream of income, and "speculative" bonds, which represent a greater risk of default but pay a higher interest rate.

The good news on muni bonds is that you don't pay federal income taxes on the interest you earn. That's why you need to consider the tax advantages when looking at a muni bond's relatively low interest rate. If you're in the 15 percent federal tax bracket, a tax-free bond saves you $150 in taxes if you're earning $1,000 in interest. Muni bonds are also free of state income taxes if the bond was issued in the state where you pay these taxes. Most mutual funds that trade municipal bonds will limit their investments to a specific state in order to offer shareholders that tax advantage.

The world of muni bonds also offers the zero-coupon bond, an interesting investment alternative. You buy these bonds at a discount to their face value and receive the face value back at maturity. The difference in price represents the compounded interest if it had been paid out every six months, as with a conventional muni. For example, a $20,000 zero-coupon bond paying 5.5 percent interest that matures in 20 years will cost you $6,757.04. At the end of 20 years, you're paid $20,000. A zero-coupon bond would be right for someone who doesn't need the interest payments, but wants to save for a distant goal, such as retirement or a kid's college eduction.