Municipal Bond Basics

In uncertain economic times investors look for safe havens for their money. One great way to diversify an investment portfolio and provide a steady safe return is by investing in municipal bonds. Municipal bonds are investment instruments where an investor pays a set amount of money for a bond issue and receives periodic interest payments as well as the face value of the bond at the end of the bond term. They can be an attractive investment because the interest payments and face value of the bond is essentially guaranteed. Municipal bonds are much less risky than investing in the stock market.

City or county government, school districts, or public airports or seaports usually issue municipal bonds to pay for infrastructure improvements or public works projects. One of the advantages of municipal bonds is that the interest payments are usually exempt from federal taxes and from state taxes in the state of issuance. Municipal bonds issued in your state of residence therefore will most likely not add to your tax burden. These attractive tax aspects give them a comparable monetary return to higher interest rate corporate bonds and municipal bonds are frequently less risky.

Municipal bonds can be purchased much like stocks from an investment firm or bank. A minimum investment is frequently $1,000, $2,500, or $5,000 per bond issue and bonds may be issued at a premium. A $1,000 bond issued at a premium, for example, might cost $1,200. The bond price would be quoted as the basis point for $1,000 worth of bond; the price would be 1.2. The $200 premium paid over the face value of the bond is what the investor pays for the future value of the interest payments over the life of the bond issue.

Municipal bonds are rated by the likelihood of default and can range from AAA down to essentially junk bonds. Municipal bonds rated A, for instance, have no more than a .23% chance that they will be defaulted. The higher the bond rating, the easier it will be to sell if you need to liquidate your investment. Municipals bonds rated lower than A may not be a good investment for that reason.

Although, municipal bonds rated higher than A are typically extremely safe investment instruments, a financial crisis like the one precipitated by the sub-prime mortgage collapse can lead to lower ratings. Some municipalities, in hard hit states for instance, were forced to consider bankruptcy as a result of the economic problems and subsequent budget crisis. Once a city faces this type of drastic economic problem, their bond ratings could be significantly lowered. Although a crisis like this will not necessarily lead to a municipality defaulting on their bond issues, a lower rating can make the bonds difficult to sell before the maturity date. Funds invested in bonds therefore, should be considered a long-term investment, but may need to be shifted from problem areas during times economic crisis. Fortunately, a careful investor should have plenty of time to sell problem bonds before the ratings are lowered too far. Bond prices can be monitored much like stock prices, and a substantial lowering of the bond price should be investigated for serious underlying problems.

Overall municipal bonds are one of the safest and most stable investment vehicles available. The tax advantages make them an attractive diversification tool and their virtually guaranteed returns are an excellent way to offset some of the risk in the rest of an investment portfolio. The default rates on municipal bonds rated A and above are extremely low, and bonds, unlike stocks, frequently offer plenty of divestiture opportunity if a problem arises.