Municipal Bonds can be a terrific vehicle to earn a reasonable rate of interest and at the same time escape taxation on the interest. For many investors who are interested in long term investments with some tax advantages the choice of a municipal bond can be attractive.
For investors looking for alternatives to qualified (IRA 401(k)) money, municipal bonds can offer many of the same benefits, long term tax advantaged vehicles. Because municipal bonds offer tax-free, compound growth with generally a satisfactory degree of liquidity, they could be an ideal choice.
What exactly is a municipal bond?
Municipal bonds are debt instruments issued by city and local governments to raise money for projects beneficial to the entire populace. Such projects could be schools, roads, bridges, public housing and utilities. Municipal bonds pay interest which can be either fixed (guaranteed) or variable (market influenced.) The issuer of the bond (municipality) receives a cash payment from the investor in return for agreeing to pay the scheduled rate of interest to the bond holder. Interest is paid over an agreed upon period of time. The time period can be from a few years to a much longer time period, such as 30 years or more. When the bond matures, the original funds are repaid to the investor.
Advantages and Disadvantages of Investing in Municipal Bonds.
- Municipal Bonds are free from Federal Taxes. Interest paid to the owner of a municipal bond is free from federal income tax liability. Some state and local taxes may still be due, depending on your state of residence.
- Tax Advantaged Compound Growth Sheltering your municipal bond investment from taxes may allow growth to compound more quickly than in a taxable account. Many mutual funds re available which only deal in municipal bonds, often earned interest is reinvested into additional bonds. Profits made by selling municipal bonds are not exempt from taxation, some mutual funds offering only municipal bonds could still have income tax exposure due to sales of bonds for a profit.
- Low Volatility. Municipal bonds are very boring when compared to investing in the stock market. Because of their nature, municipal bonds have a very low level of volatility.
- Liquidity. For the majority of municipal bonds there is a sufficient market to provide any needed liquidity when the bond is sold on the secondary market.
- Bond Yields May Not Match Inflation. Municipal bonds are lower yielding investments and may not be a long term match for inflationary issues. Municipal bonds are often considered a very conservative investment and with the tax advantage they offer combine to make interest yields on the lower side They often are less likely to keep up with inflation.
- Opportunity Cost. It is important to understand the equivalent tax yield when considering municipal bonds. While tax free can sound good, when compared to a taxable account and your income tax rate, it could be a mistake to buy municipal bonds. Tax rates are important to consider when considering municipal bonds, a low tax bracket won’t be able to capitalize on the tax advantages of a municipal bond as much as a taxpayer in a high tax bracket.
- Interest Rate Risk. When general interest rates increase, current bonds lose value. The exact opposite is also true, if interest rates decline, the value of in force bonds would increase.
- Risk of Default. Almost all investments carry some risk and municipal bonds are no different. Historically municipal bond failure has been rare, it can still happen as was recently witnessed in Southern California when Orange County defaulted on general obligation bonds.
Here is a link to more information about bond failures: http://www.municipalbonds.com/news/the-biggest-municipal-bond-disasters-of-all-time/
Summary: Municipal bonds can make sense for you if the benefits offered match up with your goals and time horizons.