Municipal bonds have long been a popular fixed-income investment option. They are issued by state and local governments and their agencies to raise money for public projects like schools, hospitals, roads and bridges.
The issuer agrees to make interest payments to bondholders at a fixed rate and repay the principal amount in full on a future date. Municipal bonds are especially appealing to investors seeking a steady flow of income, like retirees who need predictable income to meet their living expenses.
Unique Tax Status
Their unique tax status also makes municipal bonds popular: Interest is free not only from federal income tax, but also from state and local income taxes if you are a local resident. Therefore, it often makes sense to look at local bond offerings as potential investments in order to maximize tax savings.
As you evaluate local municipal bond offerings, keep in mind that there are two main types of municipal bonds. General obligation (or GO) bonds are issued to pay for general infrastructure and projects like those noted above. They are backed by the full faith and credit of the government entity that is issuing the bond. This, in turn, is determined mainly by the economic strength of the entity's tax base — or in the case of a local bond offering, the local city or municipality.
Meanwhile, revenue bonds are issued to pay for specific projects like a toll road or bridge or a public stadium. They can also be issued by specially sanctioned entities like local utilities. Revenue bonds are not backed by the full faith and credit of the government entity, but rather by fees or revenue generated by the project itself or the profits of the specially sanctioned entity (e.g., the utility company).
Two Types of Risk
There are two main types of risk when investing in municipal bonds: interest rate risk, or the risk that rising rates could erode the prices of existing bonds, and credit risk, or the risk that the issuer will default and fail to repay the principal. The latter is especially important when considering local bond offerings, as you should try to determine how likely it is that the bond issuer might default.
To assess the bond issuer's financial condition, study the bond's official statement, which is disclosed by most bond issuers when they offer new bonds for sale. This is similar to the prospectuses issued by public companies when they offer stock for sale to the public. Also, keep an eye out for event notices that announce updates to certain financial information on an annual or periodic basis.
According to the Financial Industry Regulatory Authority (FINRA), the financial condition of a bond issuer may change over time. Therefore, it is important to monitor these changes since they could affect the ability of the issuer to meet its financial obligations. Visit www.emma.msrb.org to sign up to receive alerts about the availability of important information that could affect a municipal bond.
The Role of Credit Ratings
Credit ratings are another tool that can help you gauge the potential risk of a local bond offering. The lower a municipal bond's credit rating, the higher the risk of a downgrade or default, and vice versa. However, a high credit rating is not a "seal of approval," notes FINRA, and it does not reflect or guarantee the stability of a bond's market value or its liquidity.
A low credit rating, however — or a bond without a credit rating — could very well be a sign of increased risk. "As such, a low credit rating should not be taken lightly," FINRA states on its website. "While an absence of a credit rating is not, by itself, a determinant of low credit quality, investors in non-rated bonds should be prepared to make their own independent credit analysis of the bonds," FINRA adds.
Some municipal bonds include a repayment protection feature (or bond insurance) that shields investors from default risk by insuring that principal and interest will be repaid if the bond issuer defaults. These bonds usually feature a higher credit rating and potentially lower risk. However, FINRA warns that such default guarantees are only as good as the protection agent or insurance company that is making them. "For this reason, when considering an insured bond, be sure to take into account the credit rating and long-term viability of the bond insurer," says FINRA on its website.
Local municipal bond offerings can be an attractive investment if you are seeking steady income and unique tax benefits. In addition, they also provide the opportunity to support infrastructure development in your local community. However, keep your eyes wide open when you investigate this type of investment, as there are risks as well as opportunities for tax-advantaged returns.
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