Municipal Bonds

Municipal Bonds:

Municipal bonds or “Muni’s” as they are sometimes called, are bonds issued by states, counties, cities, or other municipalities.  They are rated by bond rating companies such as Standard and Poor’s and Moody’s just like corporate bonds.  Unless the government changes things (which in this macroeconomic environment is always possible) municipal bonds are free of federal taxes. 

They are subject to state, county, city, and other local taxes under certain circumstances.  For example; if you live in New York City and invest in New York City municipal bonds then you are likely to be subject to New York, state, county, and city taxes on the income your bonds produce.  If you live in any other state other than New York then you are not subject to those taxes.   In short, if you want to buy muni’s you usually should not buy the ones from cities in the state in which you reside. 

They do not pay as much interest as corporate bonds; usually they pay in the 1% to 3% range with between 1% and 2% being most common.  By being tax free you could think of it as a corporate bond that you pay taxes on that pays about 4% is about the same as a municipal bond that you don’t pay taxes on that pays 2%.  Your individual income and tax situation will dictate your actual results this is simply a general rule of thumb or guideline. 

Are they safe?  If you buy the highest rated ones, they are mostly safe, remembering that nothing is absolutely safe.  There are two threats to municipal bonds.  First the issuing municipality could declare bankruptcy in which case you lose all the money you invested in your bond.  It has happened.  Orange County California went bankrupt several years back after their local elected officials invested their funds in very speculative investments that tanked causing the county to go broke and all their bond holders to lose their money. Second, should the federal government change the rules making municipal bonds no longer tax free, then most of the holders of municipal bonds would sell them and take their money to invest elsewhere.  As the price of all investments is controlled by the law of supply and demand, having most holders sell at about the same time would cause the value of the bonds to plummet and huge losses could be realized.  No one knows if the federal government will ever do this but they are discussing it from time to time. 

In general,  municipal bonds are held by investors who have a substantial amount of money and they are looking more for a tax shelter for their investment than to make a ton of loot.  Just think if you make 2 million dollars a year why would you want to risk it?  Rich folks often invest in government and municipal bonds to keep their money safe and in the case of the muni’s,  to avoid paying taxes.  I don’t think that muni’s are a good investment for the small investor, but in the end, it is up to you to do what you wish with your money.

Remember that on average inflation runs around 3% a year so if you are only making between 1% and 2% on your investment you are losing money to inflation every year.  Which is ok if you have millions of dollars but it is not so good if you just have a few hundred thousand or less to last you the rest of your life.  As always contact a certified investment planner who sells nothing but advice before investing.   Remember my writings are simply to educate and not to advise you what to invest in. 

Other than what is stated above, municipal bonds work pretty much like corporate bonds in that they pay out usually every quarter, have a maturity date, are rated by the bond rating services, and some may be callable. As in the case of all types of bonds, they may pay quarterly, semi-annually, or annually.  The main difference is they are federal tax free, pay a lower interest rate, and are backed by local governments and not by companies or the federal government.

Copyright 2012, Greg High, all rights reserved.