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Municipal bonds & how they work

Municipal bonds & how they work

Municipal bonds are loans that investors such as cities, countries, states, and other government agents give to the local government. The investor gets the loan plus interest, tax-free for investors of that state. Although the market is worth above $3.9 trillion as of 2020, these bonds are also securities available in the open market. As a result, market bonds experience price changes, but the changes will not affect your return until maturity. 

How They Work

Municipal bonds attract interest to investors. The interest accumulates twice yearly, and the bond issuer remits the principal amount on the maturity date. Bonds are usually three years for the short-term and ten or more years for the long-term. This is the best way to get tax-free interest. Unlike taxable bonds, the claim is not subject to federal, state, or local tax laws resulting in low-interest rates. You can get municipal bonds from authorized sellers or a municipal bond fund. 

Types of municipal bonds

There are two options for municipal bonds – general obligation and revenue bonds. Both options have pros and cons that you should investigate them before embarking on any.

General obligation bonds

General obligation bonds are given to the government to fund public projects like building a public park or revamping a school system. They focus on things that improve the community instead of making money. The bonds are supports made based on the issuer's faith and credit, meaning the bondholder's interest rate or worth during repossession is not certain. 

Revenue bonds

Revenue bonds are specifically for funding revenue-generating projects like tool gates or concert halls. Municipalities give the bond to receive their investment after the project starts generating funds. The interest rates are higher because they are used for projects that may or may not be completed according to plan and may not yield the expected revenue. 

How to invest in municipal bonds

You can invest in municipal bonds through:

  • New issues

  • The secondary market

  • Bond funds

New issued bonds are used for new projects by the municipality. The secondary market sells bonds from different issuers or sells bonds that are yet to mature and are held by investors. Bond funds are funds that own bonds and are open to investment. 

Risks Of Investing in Municipal Bonds

However, municipal bonds also come with risks like other investments. There are several risks associated with municipal bonds, such as:

Call risk. The call risk is when an insurer is expected to repay the bond before the maturity date, especially when there is a drastic decline in interest rate. For example, a homeowner may refinance a mortgage loan due to low interest. However, if the interest rate is stable or gaining height, the call may be difficult.

Credit risk. Credit risk is when the insurer is experiencing a financial problem and cannot fulfill the bond interest and principal. The process is known as default and applies to many bonds. Credit rating measures credit risk, although increasing rating does not assure default-free bonds.

Interest rate risk. Every bond has a fixed face value, referred to as par value. When a bond reaches maturity, the holder gets the face value plus interest at a fixed or floating rate. The bond will gain momentum when the interest rate declines and loses its value when the interest rate increases. 

Inflation risk. Generally, inflation affects every part of the economic sector, including bonds. It leads to an increase in interest rates which reduces the bond's par value. 

Liquidity risk. Investors may not get an active open market to sell bonds, which affects the buying and selling of bonds. This also affects the price placed on the bond. The action makes it difficult to trade them at a certain price.



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