Guide to Municipal Bonds

The world of finance is full of choices. Depending on what kind of an investor you are, you could invest in a hundred different instruments. If you are the risk taking types, you can invest in the stock markets and mutual funds. If you are the non risk taker, you could invest in debt instruments and bonds. Bonds are issued by corporates as well as by government bodies, both state and federal. Municipal bonds are issued by the state counties and are ideal for the residents those specific counties.

What are municipal bonds?

All bonds work on the same principle; that of raising capital and even repayment with interest. Municipal bonds, popularly known as "Munis", are debt securities that states, cities, counties and other governmental entities issue to raise money for public purposes, such as building schools, highways, hospitals, sewer systems, and other special projects. A bond purchaser lends the issuer (municipality), money on the condition that it will be returned back to him after a specific period of time with the applicable interest. Repayment periods can be as short as a few months (although this is rare) to 20, 30, or 40 years, or even longer.

How do municipal bonds work?

Municipal bonds are bought and sold in the over-the-counter market rather than on an organized exchange. These bonds are bought, sold and priced on the basis of credit quality, maturity, liquidity and yield. While the interest payment on most bonds is fixed, the market price of a security changes as market conditions change. If an investor sells his or her municipal bond prior to maturity, he or she will receive the current market price, which may be more or less than the original price.

The probability of repayment by the issuer as promised is often determined by an independent reviewer, or "rating agency". The three main rating agencies for municipal bonds in the United States are Standard & Poor's, Moody's, and Fitch. The classification of municipal bonds is based on these ratings. Tough there are many types of bonds, the main types being tax-free municipal bonds and high-yield municipal bonds. Even though there are many kinds of municipal bonds the ones most popular being tax saving bonds and high yield bonds.

Tax-free bonds are exempt from taxes. Some might be exempt from both federal and state taxes but usually in most cases federal taxes are not exempt.

Bonds are subject to risks like interest rate risk and credit risk, inflationary risk, liquidity risk, default risk, market risk and political risk. High-yield municipal bonds have higher risks but yield much higher gains than normal bonds. They are more risky since the issuer may default on the payments. The rating agencies usually place a low rating on these bonds.

Before investing in municipal bonds, an investor should consider the pros and cons.

Advantages:

1. Assured returns:
Since the securities are sponsored by the government, the returns will always be assured, even if they are low in yield.

2. Tax free:
Almost all the bonds are tax free which accounts for huge savings

Disadvantages:

1. Lower returns:
However much the yields from bonds, they cannot be compared to the returns from stock market instruments like mutual funds.

2. Risks:
However safe the bonds are, they are not averse to risks.

Municipal bonds yield higher returns than usual debt instruments and are less risky than stock market instruments. It is advisable to have a balance between secure bonds and high-yield bonds so there is a maximum returns can be gained from the investments.