The basics

Bonds are loans investors make to the federal government, state governments, municipalities, companies, and government agencies.

What are municipal bonds?

Issued by states, counties, cities, and towns, municipal bonds pay for public works projects such as highways and new schools. When investing in municipal bonds, the investor loans money to a municipality for a specific project. The bond investor, called the bondholder, receives an I.O.U. from the issuing municipality.

Most municipal bonds are fixed-income securities. The municipality pays the bondholder a predetermined interest rate, called the coupon rate, on a regular basis, also predetermined. All bonds have a set maturity date, the date on which the bond issuer promises to pay back the loan amount in full.

Municipal bonds fall into three categories based on the length of time between the issue of the bond and the maturity date. Short-term bonds are one year or less. Intermediate-term bonds run 2-20 years. Long-term bonds run 20-40 years. The longer the term, the higher the risk and the higher the rate of return.

Tax-free municipal bonds

Investment income from municipal bonds is exempt from federal income taxes. In addition, many states exempt income earned on bonds issued within their borders. That does not, however, mean municipal bonds are always the best choice.

On account of their tax-exempt status, municipal bonds generally provide lower yields than comparable taxable bonds issued by the federal government or corporations. Investors need to compare after tax yields on taxable bonds based on their own tax bracket with yields on tax-free municipal bonds to determine the better investment. In short, those investors in high tax brackets are more likely to benefit from municipal bonds than investors in low tax brackets.

Because investment income earned within a Roth IRA is already tax-exempt, funding one’s retirement account with tax-free municipal bonds becomes unnecessary. If you are eligible for a Roth IRA and wish to fund your retirement with bonds, then higher-yielding U.S. government or corporate bonds are the proper choice.

High-yield municipal bonds

A bond’s yield refers to the rate the bondholder earns on his or her investment. Common sense, therefore, dictates that high-yield municipal bonds provide a greater return on investment. Further application of investment basics denotes the higher the return on investment, the higher the investment risk. Because of this risk, individuals who want high-yield municipal bonds as part of their portfolio generally diversify by investing in mutual funds that emphasize high-yield municipal bonds.

Knowledgeable investors, those aware of potential risks and rewards, seeking high, tax exempt income should consider high-yield municipal bonds. In addition, high-yield bonds are less sensitive to general interest rate trends and changes in Federal Reserve policy. Committing a portion of one’s fixed-income investments, therefore, to high-yield municipal bonds lessens a portfolio’s volatility as interest rates rise and fall.

Conclusion

Always remember: the best investment you can make is an investment in your education. Make sure you are aware how investing in municipal bonds fits into your overall investment plan. Even if you decide not to invest in municipal bonds, you’ll at least be able to answer the question, What are municipal bonds?