What is a Municipal Bond?

People invest in bonds for many different reasons. Some prefer the relative security of bonds when the stock market is experiencing overall poor performance. Others may be nearing retirement and hope to minimize risk to their funds. Some use bonds to diversify their portfolios and others like the income. One type of bond favored by investors is the municipal bond.

A city, county or state issues a municipal bond to fund public projects such as building schools or highways. By buying a municipal bond, an investor is lending money to the issuer for the projects. In return, the issuer agrees to pay interest periodically and to return the money paid, or principal, to the investor on the bond's maturity date.

There are two basic categories that municipal bonds, also known as "munis," fall into: revenue bonds and general obligation bonds. General obligation bonds are backed by the issuer's ability to raise money through taxes. Revenue bonds are issued for a specific project and pay interest and repay the bonds with funds earned from the project. For example, a bond may be issued to cover the cost of building a toll bridge, with interest to be paid from the tolls charged to cross the bridge.

Municipal bonds offer several attractive advantages. They can provide a steady stream of income from interest and can be sold before the maturity date. However, their most popular feature is that they're tax-exempt. The federal government doesn't tax interest income generated on municipal bonds. Nor does the state if a resident of the state in which it was issued bought the bond. Taxes are charged, however, for gains made from selling the bond.

Like any other investment, however, municipal bonds carry risks. The investor could lose his principal if the issuer defaults on some debt. One famous case was the default of Orange County, California in 1994. Investors were shocked when this affluent county with good ratings from analysts filed for bankruptcy and defaulted on its municipal bonds.

One way to avoid this is to examine the issuer's financial situation prior to the sale. Documents called "official statements," or "offering documents" are filed with the Municipal Securities Rulemaking Board (MSRB) and can be obtained from the MSRB's Municipal Securities Information Library for a fee. Brokerage firms and banks can also provide official statements.

Investors can also consult ratings agencies such as Standard & Poor's, Fitch and Moody's. These agencies analyze the bond and assign it a credit rating from AAA to D based on their belief that the issuer will be able to refund the principal on the bond's maturity date. Municipal bonds with a credit rating of AAA or AA are considered the safest by the ratings agencies, and investors can minimize the risk of default by only investing in these bonds. Bonds rated A, Baa or BBB are more risky, but still investment grade. Bonds with ratings of Ba, BB or less are called "junk bonds" and are considered to be at high risk for default.