Municipal Bond: Definition, Types, Risks, and Tax Benefits

Summary:

In this blog, we try to understand what municipal bonds are and their different types, while also covering the associated risks. We'll also explore the many tax benefits associated with municipal bonds that make them an attractive investment option.

Municipal bonds play a crucial role in financing public projects and infrastructure development across the country. State or local governments often raise the capital for such projects from investors that, in turn, get a regular and fixed interest in return till its expiration. Municipal bonds are therefore an indispensable part of global financial markets. This is mainly because they provide the investors with regular and safe income. In this article, we will unearth everything there is about municipal bonds for your better understanding.

Definition

Municipal bonds, commonly known as "munis," are best explained as fixed-income investments or debt securities, usually issued by governmental bodies to raise funds for various public purposes. These government bodies can include school districts, cities, states, or even countries. The government takes a loan from investors who receive a fixed and regular income as an interest on the loan. Fixed-income securities, also known as fixed-income investments or debt securities, are financial instruments representing a loan made by an investor to an issuer, typically a government or corporation. When the tenure of a fixed-income security ends, the investor receives the full loan amount.

Type of municipal bonds

There are three main forms of municipal bonds issued by government entities. Each municipal bond caters to different investor preferences and municipal financing needs. To understand them better, let us explore them in detail.

1. General Obligation Bonds (GO Bonds): These municipal bonds are one of the most common and widely recognized forms of municipal debt securities. The government usually uses this to finance its general operations like education, healthcare, economic development, etc. Since the government uses these bonds for essential operations, GO bonds are considered one of the safest types of municipal bonds. These are backed by the full faith, credit, and taxing authority of the issuing governmental body.
2. Revenue Bonds: Revenue bonds are issued by state and local governments to finance specific projects or facilities that generate revenue. These sources can include highway tolls, sports stadium revenue, seaport revenue, etc. Thus, unlike GO bonds, these bonds are backed by the income that is generated from the financed project. Hence, they do not rely on the government’s general tax revenue for repayment. This makes them risky but with the potential to offer higher yields.
3. Industrial Development Bonds (IDBs): Private businesses which require construction are usually financed by taking loans in the form of IDBs. This is thus the standard municipal bond for the expansion of private businesses, such as manufacturing facilities or hospitals. These bonds are supported by the business itself and do not require the backing of government institutions.

Risks Associated with Municipal Bonds

Municipal bonds are largely considered a safe investment from the perspective of an investor. This is because they have the backing of the government body. That said, it is not entirely risk-free and therefore you must invest with caution. Some potential risks posed by municipal bonds include-

1. Credit Risk: While the interest payment for municipal bonds is regular, there is a slight risk of governments being defaulters if they face financial difficulties. To assess this, you can obtain the credit rating of the institution through credit rating agencies. This will give you an idea of whether to proceed or not.
2. Interest Rate Risk: Like all fixed-income investments, municipal bonds are also capable of changing interest rates. The market value of existing bonds may fall when there is an increase in the rate of interest.
3. Call Risk: While most municipal bonds reach their tenure, some may be called before that. The issuer can redeem them before maturity for numerous reasons. This has a bearing on the investor's expected earnings and the return on investment.

Tax Benefits of Municipal Bonds

Now that we are acquainted with the risks, let us delve into the plethora of tax benefits exercised by municipal bonds.

1. Tax-Exempt Interest: The interest income received from most municipal bonds is exempt from federal income taxes. Also, municipal bonds issued by your state of residence are exempt from state income taxes.
2. Alternative Minimum Tax (AMT) Exemption: Some municipal bonds are exempt from the AMT. AMT is a tax system designed to ensure that high-income taxpayers pay the minimum level of tax.
3. Tax-Efficient Income Stream: Tax-free interest payments provide an attractive prospect for investors who fall in the category of high tax brackets as this provides them a tax-efficient source of income.

Conclusion

Municipal bonds are crucial in the financial landscape and form the backbone of public projects. They offer a steady source of income to the investors along with potential tax advantages. However, like any other financial instrument, municipal bonds need a closer look before entering. Each municipal bond type comes with its own risks and understanding them helps make informed investment decisions. As an investor, municipal bonds can be a prized addition to your investment portfolio and help reduce your tax liability. Consultation with a financial advisor will determine the suitability of municipal bonds for your specific financial goals and circumstances.