Municipal securities, or “munis,” are bonds issued by states, cities, counties, and other government bodies to raise funds for public projects such as roads, schools, and other infrastructure.
Munis pay a predetermined amount of interest (typically semiannually) and refund the principle on a predetermined maturity date. The majority of municipal bonds are offered in $5,000 increments and have maturities ranging from 2 to 5 years to very long (30 years).
When considering a municipal bond investment, keep in mind that no two municipal bonds are alike, and carefully assess each one, making sure to get the most up-to-date information on both the bond and the issuer. See FINRA’s Investor Alert Municipal Bonds—Important Considerations for Individual Investors for further information.
Buying and Selling Munis
Some municipal bonds have a higher level of liquidity than others. Some bonds trade frequently, while others may go weeks without any activity (no interested buyers or sellers). Municipal bonds, in general, are more susceptible to supply and demand pressures than other fixed-income securities. As a result, you’re taking on more market risk: If your bond is out of favor with other investors when you need to sell it, the price you get in the secondary market will fall. Of course, munis, like all bonds, are susceptible to interest rate risk: if rates rise faster than your bond’s rate, the bond’s secondary market value drops.
Because of the overwhelming amount of muni bonds available and the tremendous competition among dealers for a piece of the pie, muni investment should be approached with caution. Do your homework, beginning with selecting an investment professional with a track record of success in municipal securities.
When considering a municipal bond investment, keep in mind that no two municipal bonds are alike, and carefully assess each one, making sure to get the most up-to-date information on both the bond and the issuer.
Munis and Taxes
The principal reason why most private investors purchase municipal bonds is to benefit from preferential tax treatment on the interest they earn. The great majority of municipal bond interest is tax-free in the United States. Indeed, municipal securities are the only ones that fall within this category.
Furthermore, if you live in the state or city that issued the bond, your interest income may be exempt from state or city taxes. Residents of all states are excluded from paying taxes on bonds issued by Puerto Rico, Guam, and other US territories.
The federal government does not exclude all municipal bonds from taxation. Municipal bonds that are taxable may be issued to fund projects that the federal government would not fund. To make up for the lack of a tax advantage, these bonds often have higher yields than tax-exempt municipal bonds, and are more in line with corporate or agency bond rates.
The AMT (alternative minimum tax) is a tax that some persons must pay. The AMT is calculated using a separate set of principles than your regular income tax calculation, but you must pay whichever calculation is higher. The AMT may apply to investors who buy “private activity” municipal bonds, which are bonds that aren’t solely used for government activities. Interest gained on these “private activity bonds” cannot be deducted under AMT rules, unlike interest earned on other municipal bonds, including 501(c)(3) private activity bonds, and may result in an AMT payment. Before advising a tax-exempt investment, a reputable financial adviser should assess your AMT liabilities. A tax professional’s counsel is also recommended.
Is it true that the federal government issues municipal bonds?
Municipal bonds (also known as municipal debt) are a type of debt “State, city, county, and other local agencies issue debt securities to support day-to-day commitments as well as capital projects such as the construction of schools, roadways, and sewer systems. When you buy municipal bonds, you’re effectively lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or a combination of the two “I am the principle.” The maturity date of a municipal bond (the day on which the bond’s issuer repays the principal) could be years away. Short-term bonds will mature in one to three years, whereas long-term bonds will take a decade or more to maturity.
Municipal bond interest is generally tax-free in the United States. If you live in the state where the bond was issued, the interest may be free from state and local taxes. Bond investors are often looking for a consistent stream of income payments and, when compared to stock investors, are more risk conservative and concerned with preserving rather than developing capital. Due to the tax benefits, tax-exempt municipal bonds typically have lower interest rates than taxable fixed-income assets such as corporate bonds with equal maturities, credit quality, and other characteristics.
- States, cities, and counties issue general obligation bonds that are not backed by any assets. General obligations, on the other hand, are backed by the government “the issuer’s “full faith and credit,” which includes the ability to tax inhabitants in order to pay bondholders.
- Revenue bonds are backed by earnings from a specific project or source, such as highway tolls or lease fees, rather by the government’s taxing power. Some revenue bonds are available “The term “non-recourse” refers to the fact that bondholders have no claim to the underlying revenue source if the revenue stream ceases to exist.
Municipal borrowers also occasionally issue bonds on behalf of private businesses such as non-profit universities and hospitals. The issuer, who pays the interest and principal on the bonds, often agrees to reimburse these “conduit” borrowers. The issuer is usually not compelled to pay the bonds if the conduit borrower fails to make a payment.
Where can investors find information about municipal bonds?
The Municipal Securities Rulemaking Board’s Electronic Municipal Market Access (EMMA) website makes municipal securities documentation and data available to the public for free. You will have access to:
- Economic reports and events that may have an influence on the municipal bond market are listed on this calendar.
It’s worth noting that many issuers have dedicated websites or webpages for municipal bond investors. Some issuers link to those pages from their EMMA main page. Learn how to use EMMA to locate issuer homepages.
In 2009, the Securities and Exchange Commission recognized EMMA as the official depository for municipal securities disclosures. The MSRB is supervised by the Securities and Exchange Commission (SEC). The MSRB is a self-regulatory body whose objective is to promote a fair and efficient municipal securities market in order to safeguard investors, state and local governments, and other municipal entities, as well as the public interest. The disclosure materials are not reviewed by the SEC or the MSRB before they are posted on EMMA.
What are some of the risks of investing in municipal bonds?
Municipal bonds, like any other investment, carry certain risk. Municipal bond investors are exposed to a number of dangers, including:
Call it a gamble. Call risk refers to the possibility of an issuer repaying a bond before its maturity date, which could happen if interest rates fall, similar to how a homeowner might refinance a mortgage loan to take advantage of reduced rates. When interest rates are constant or rising, bond calls are less likely. Many municipal bonds are “callable,” thus investors who plan to hold a bond to maturity should look into the bond’s call conditions before buying it.
There is a credit risk. This is the risk that the bond issuer will run into financial difficulties, making it difficult or impossible to pay interest and principal in full (the inability to do so is known as “default”). For many bonds, credit ratings are available. Credit ratings attempt to measure a bond’s relative credit risk in comparison to other bonds, yet a high grade does not imply that the bond would never default.
Interest rate risk is a concern. Bonds have a set face value, which is referred to as the “par” value. If bonds are held to maturity, the investor will get the face value of the bond plus interest, which might be fixed or variable. The market price of the bond will grow as interest rates fall and fall as interest rates rise, hence the market value of the bond may be greater or lesser than the par value. Interest rates in the United States have been historically low. If interest rates rise, investors who hold a cheap fixed-rate municipal bond and try to sell it before it matures may lose money due to the bond’s lower market value.
There is a chance of inflation. Inflation is defined as a widespread increase in prices. Inflation diminishes purchasing power, posing a risk to investors who are paid a fixed rate of interest. It may also result in higher interest rates and, as a result, a decrease in the market value of existing bonds.
There’s a danger of running out of cash. This refers to the possibility that investors may be unable to locate an active market for the municipal bond, prohibiting them from buying or selling the bond when they want and at a specific price. Because many investors purchase municipal bonds to hold rather than trade them, the market for a given bond may be less liquid, and quoted values for the same bond may range.
In addition to the risks, what other factors should you consider when investing in municipal bonds?
There are tax implications. Consult a tax specialist to learn more about the bond’s tax ramifications, such as whether it’s subject to the federal alternative minimum tax or qualified for state income tax benefits.
Brokerage commissions. The majority of brokers are compensated by a markup on the bond’s cost to the firm. It’s possible that this markup will be revealed on your confirmation statement. If you are charged a commission, it will appear on your confirmation statement. You should inquire about markups and commissions with your broker.
Are corporate bonds issued by municipalities?
When deciding whether to purchase corporate or municipal bonds, there are a number of considerations to consider. The quality of the corporation issuing the bond, the tax consequences, yield, liquidity, and how the money earned through the issuance of the bond will be used are some of the most important of these variables.
Quality of Issuer
The issuer’s quality is one of the first things you should look into before buying a bond or any other financial instrument. Bond issuers will have varying credit ratings, which means that investing in the securities they’ve made accessible exposes you to credit risk.
Bond issuer credit ratings are provided by two agencies: Moody’s and Standard & Poor’s. The rating scale used by Moody’s spans from C to AAA, with AAA being the highest attainable grade. Standard & Poor’s has a rating system that ranges from D to AAA, with AAA being the highest attainable rating.
Higher ratings indicate that the bond’s issuer is less likely to default. After all, individuals who invest in the security stand to lose if the corporation that issued it fails to meet its obligations.
Corporate Bonds Come With Higher Default Rates
Corporations issue corporate bonds, and each corporation is distinct. Some people make more money than others, some have superior management teams, and some will continuously fulfill their duties while others will fail.
Instruments issued by corporations have a higher default risk than municipal bonds, therefore it’s very crucial to pay attention to how rating agencies grade the bond before you invest.
The good news is that even businesses rarely go bankrupt. Only approximately 0.13 percent of companies that issue bonds default, according to the Corporate Finance Institute.
Tax Implications
You must pay taxes on all income you earn, whether it is from a side hustle, your day job, or investment returns. However, not all forms of income are taxed in the same way. When determining whether to invest in corporate or municipal bonds, consider the following tax effects.
How Corporate Bonds Are Taxed
Corporation-issued bonds are sometimes referred to as taxable bonds since the revenues earned from these investments are subject to both federal and state income taxes at the general income tax rate. Your tax bracket determines the exact rate you’ll pay on your returns.
How Municipal Bonds Are Taxed
Gains from municipal bond investments are always tax-free on the federal level and are frequently tax-free on the state level as well. The tax exemption is effectively a “thank you” from both the federal and local governments for investing in projects that benefit your community with your money.
While munis are immune from state and local taxes in the vast majority of circumstances, this is not always the case. If you buy a municipal bond from a municipality other than the one where you live, for example, your local authorities may choose to tax the bond’s returns at the usual local income tax rate.
For example, if you live in New York City and invest in a municipal bond issued by a government body in Florida, New York City may charge you its standard local tax rate on the investment’s profits.
Yields
Bond yields fluctuate dramatically based on the credit of the issuing institution, the maturity period of the bond, and other considerations.
In general, the following is how corporate and municipal bond yields compare:
Corporate Bonds Generally Have Higher Yields
Local governments are well-respected institutions with a track record of good financial management. Corporations, on the other hand, will have a wide range of financial strength and creditworthiness.
Corporate bonds have higher interest rates than government bonds because companies are typically less creditworthy than governments. After all, if corporate bond yields were the same as government bond yields, no one would lend to riskier businesses. Who wants to buy a corporate bond when you may get the same returns by investing in lower-risk municipal bonds?
Munis Provide Small Gains
Bonds issued by the government have a lower risk of default, making them a safer option for investors. When it comes to investing, however, safer options tend to yield lesser returns, and municipal bonds are no exception.
These bonds’ pricing takes into account the extremely minimal default risk, resulting in lower interest rates, smaller interest payments, and poorer overall returns.
That is, until taxes are included in. A high-income earner, for example, may discover that municipal bonds are a better fit because they are tax-free on both the state and federal level. For an investor in the highest tax bracket, however, much of the profit on corporate bonds would be wiped out by taxes.
Liquidity
Whether investing in bonds or any other asset, investors should constantly consider liquidity. The ease or difficulty of changing an investment back into cash, if desired, is referred to as liquidity.
Bonds with low liquidity will be difficult to convert into cash before their maturity dates, whereas bonds with high liquidity will be easy to dump and change into spendable money on demand.
Corporate Bonds Are Often Less Liquid
While any type of bond can be sold on the secondary market, there must be a buyer for the bond to be sold. Investments in high-risk bonds and other corporate bonds may become illiquid in some situations if no other investors are interested in buying them.
Furthermore, when the economy and markets are doing well, bond liquidity decreases. During bull markets, investors prefer not to have their money invested in fixed-income assets, preferring instead to focus on the higher return potential of equities.
Municipal Bonds Are Highly Liquid
The municipal bond market is quite active, and municipal bonds are often easier to sell than corporate bonds. Because muni bonds are issued by entities that are almost certain to meet their commitments while also delivering tax benefits, they are appealing investments for high-income individuals.
How Funds Are Used
Investors are becoming increasingly worried about how their money is being used. In fact, there’s a whole industry devoted to social impact investing, which is investing in assets that use your money to help causes you care about.
So, when you invest in these two different sorts of bonds, how is your money spent?
How Corporations Use Money Raised Through Bond Sales
Corporations may need to raise capital for a variety of reasons. The following are a few of the most common:
- Working Capital is a term used to describe the amount of money Making money takes money, and maintaining a business can be a costly task. Corporations may need working capital for general purposes if their money is locked up in inventory, new equipment, and other assets required to keep them moving in the correct direction. Companies can issue bonds to raise cash for immediate operational requirements while pledging to repay investors later.
- Acquisitions. Companies frequently merge with one another, resulting in deals in which the total worth of all pieces exceeds the value of the original assets. Acquisitions, on the other hand, are a costly business, and companies frequently require additional capital to complete merger and acquisition deals.
- Research. Almost every publicly traded firm on the market today spends a significant amount of money on research and development. Corporations may issue bonds to fund this research in some instances.
How Municipalities Use Money Raised Through Bond Sales
The vast majority of government-issued bonds are used to fund public-sector initiatives.
When a major thoroughfare is riddled with potholes or your county’s library needs to be repaired, for example, governments frequently issue bonds to cover the costs of these projects. Governments can repay investors either through project revenue or tax revenue generated by the projects they fund.
What company issues bonds?
A bond is a guarantee from a borrower to repay a lender with the principal and, in most cases, interest on a loan. Governments, municipalities, and corporations all issue bonds. In order to achieve the aims of the bond issuer (borrower) and the bond buyer, the interest rate (coupon rate), principal amount, and maturities will change from one bond to the next (lender). Most corporate bonds come with alternatives that might boost or decrease their value, making comparisons difficult for non-experts. Bonds can be purchased or sold before they mature, and many are publicly traded and tradeable through a broker.
Bonds are paid for by taxpayers.
Putting “no tax increase” in front of “bonds” is designed to dampen opposition to increased taxes, as it is with many political words. But, to be clear, there is no category of bonds issued by school districts that does not result in an increase in your taxes. Bonds with no tax increase raise your taxes.
How? Bonds are frequently issued by school districts to fund capital projects such as the construction of new facilities or the renovation of existing infrastructure. The bonds are paid off over time by the taxpayers, usually through an increase in their property taxes. Bonds are issued for a set period of time, and when they are paid off, the tax payments of the taxpayers are reduced.
What is the source of bond money?
A bond is just a debt that a firm takes out. Rather than going to a bank, the company obtains funds from investors who purchase its bonds. The corporation pays an interest coupon in exchange for the capital, which is the annual interest rate paid on a bond stated as a percentage of the face value. The interest is paid at preset periods (typically annually or semiannually) and the principal is returned on the maturity date, bringing the loan to a close.
Municipal bonds are issued in several ways.
Municipal bonds are worth considering if your primary investing goal is to protect capital while receiving a tax-free income stream. Municipal bonds (also known as munis) are debt obligations issued by government agencies. When you purchase a municipal bond, you are essentially lending money to the issuer in exchange for a specified number of interest payments over a set period of time. When the bond reaches its maturity date at the end of that time, you will receive the whole amount of your initial investment back.
What are the differences between municipal and corporate bonds?
Bonds appeal to many investors because they provide a stable income stream without the risk associated with the stock market. However, not all bonds are made equal, and if you’re wanting to diversify your portfolio, you should examine both corporate and municipal bonds. A corporate bond is a financial instrument issued by a firm to raise capital, whereas a municipal bond is a debt instrument issued by a city, municipality, or state to fund public initiatives. Corporate bond interest is always taxed, despite various tax exemptions for municipal bond interest. Corporate bonds, on the other hand, usually have greater yields.
In 2021, are municipal bonds a decent investment?
- Municipal bond interest is tax-free in the United States, however there may be state or local taxes, or both.
- Be aware that if you receive Social Security, your bond interest will be recognized as income when determining your Social Security taxable amount. This could result in you owing more money.
- Municipal bond interest rates are often lower than corporate bond interest rates. You must decide which deal offers the best genuine return.
- On the bright side, compared to practically any other investment, highly-rated municipal bonds are often relatively safe. The default rate is quite low.
- Interest rate risk exists with any bond. You’ll be stuck with a bad performer if your money is locked up for 10 or 20 years and interest rates climb.
Is municipal bond interest taxable?
Residents of the issuing state are generally excluded from federal and state taxes on income earned from municipal bonds. While interest income is tax-free, any capital gains delivered to the investor are taxable. The Federal Alternative Minimum Tax may apply to some investors’ earnings (AMT).