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What is a Municipal Bond ?
A municipal bond is a bond that is
issued by a state or a political subdivision such as a county,
city, town or village. The term also refers to the bonds issued
by state agencies and authorities. Such bonds are normally
issued to raise money for public projects like construction of
highways, public works, school buildings, hospitals or sewer
systems. Often interest from municipal bonds is exempt from
taxes. They are also known as Muni bonds.
When you buy a municipal bond, you are loaning money to the
issuer in exchange for a fixed number of interest payments over
a predetermined period. At the end of that period, the bond
reaches will its maturity date and the full amount of your
original investment will be returned to you. Municipal bonds are
available in both taxable and tax-exempt formats and the
tax-exempt bonds are the most popular because the income they
generate is exempt from federal and, in many cases, state and
local income taxes. Certain municipal bonds are subject to the
alternative minimum tax (AMT).
Tax-exempt municipal bonds are among the most popular types of
investments available today. There are a lot of benefits to
purchasing the bond including:
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• Attractive income free from
federal and, in some cases, state and local taxes.
• High degree of safety with regard to payment of interest and
repayment of principal.
• Steady and predictable source of income.
• Range of choices to choose from depending on investment
quality, maturity, choice of issuer, type of bond and
geographical location.
• Marketability in the event you must sell before maturity.
Types of Municipal Bonds
There are two types of municipal bonds: General obligation bonds
and Revenue bonds
General obligation bonds General obligation bonds or GO bonds,
as they are commonly called, are legally backed by the full
faith and credit of the issuing authority. In other words, the
government is required to repay the debt. |
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Advantages
• GO bonds are considered low risk and sell at the lowest rates
of interest.
• They are not as complex as other bonds and so have lower
administrative costs in preparing the issue.
• Since these require approval through a bond referendum by the
voters, there is popular support for the project or program that
is being financed.
Disadvantages
• Because of its dependency on voter approval, there may be
delays in the financing of projects.
• If voters do not approve the bonds, officials must devise
alternative methods of financing the project, or cancel the
project outright.
• GO bonds typically pay lower interests.
• The ability to issue general obligation bonds may be
constrained by legal debt limits.
General obligation bonds, like most municipal bonds, are
typically sold in denominations of $5,000. While it is sometimes
possible to buy directly from the municipality, most GO bonds
are purchased on the secondary market. A number of mutual-fund
companies offer shares in managed open-end or closed-end
municipal security funds.
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Revenue
Bonds
A revenue bond is bond supported by the revenue from a specific
project, such as a toll bridge, highway, or local stadium and
can be repaid only from revenues earned from the specific
projects. GO bonds can be repaid through a variety of sources.
Since revenue bonds are not backed by the issuer's taxing
authority they are generally considered more risky than general
obligation bonds and therefore tend to offer higher interest
rates.
How Safe Are Municipal Bonds ?
The primary concern when you invest in any bond should be
whether the bond issuer can meet the financial obligations or
not. Municipal bonds have an outstanding record of paying
interest and repayments in a timely manner. Their financial
condition is regularly disclosed through “official statements”
or “offering circulars,” which are available from your bank,
brokerage firm, on the Internet or from a library of official
statements. |
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Checking the issuer’s credit rating will
also help in making sure the bonds are safe to purchase. Many bonds
are graded by rating agencies such as Moody’s Investors Service,
Standard & Poor’s and Fitch Ratings. A number of banks and brokerage
firms have their own research departments which also analyze
municipal securities. Bond ratings are important benchmarks because
they reflect a professional assessment of the issuer’s ability to
repay the bond’s face value at maturity. Generally, bonds rated BBB
or Baa or by Standard & Poor’s and Fitch, or Moody’s are considered
suitable for investment.
Bonds with Special Investment Features
There are several other types of municipal bonds:
Insured municipal bonds Many
municipal bonds are backed by insurance as a means to reduce
investment risk. In the unlikely event that there is a default, the
insurance company will pay both the interest and principal when they
are due. This makes it the safest municipal bond for investment.
Floating-rate and variable-rate bonds
The interest rate on these bonds changes periodically depending on
the market conditions. Interest is reset based upon a percentage of
prevailing rates for Treasury bills or other interest rates. These
bonds are a good investment in a rising-interest-rate environment.
Zero-coupon, compound-interest and
multiplier bonds There is no interest paid on these bonds
and are usually issued at a deep discount of the face value. When it
matures, the investor will receive a one-time payment of the
principal amount and the interest accrued at the original interest
rate. They are usually long-term bonds – five, ten or fifteen years
- and are a good investment choice for long-term financial goals
such as retirement planning or college fees.
Put bonds These bonds have a
feature whereby the investor can force the bond issuer to buy back
the bonds at certain specified dates at the current interest rates.
It can either be an one-time “put” feature where the bonds can be
“put” back for repurchase once or number of different dates during
the bond period.
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Article Contributed By: Jaya Suresh
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