What is a Municipal Bond, and How Does It Work?

Whenever you hear of municipal bonds, so many things come to mind. While some may view it as an overhyped investment portfolio, others believe that there is significant gain. A municipal bond is a security.

This security emanates from either state, a county, municipality, and any other government body. As debt security, funds raised through this bond are channeled towards the building of infrastructure in the community.

Another way of explaining a municipal bond is likening it to a loan. These bonds are issued to members of the public who may be interested in them. The money paid is then used in carrying out capital projects such as the building of schools, hospitals, and road construction. The catch is that the money raised by the government through this bond is plowed into the community.

Investing in a municipal bond means lending the monetary equivalent of the bond to the issuer. The investor, therefore, becomes entitled to regular interest payments on the bond. The interest for most municipal bonds is paid bi-annually for a specified period before the interest is paid back.

 The time of maturity of a municipal bond depends on whether it is long-term or short-term. A short-term bond matures within one to three years while a long-term bond can stay as long as 20 years before maturity. Municipal bonds are also known as ‘munis’.

Features of municipal bond

Certain features are peculiar to a municipal bond. Understanding these features will help you know if it is the right kind of investment for you. These features include:

  • There is a fixed price: Municipal bonds are issued at a specific price. The price is determined by so many factors such as the quality of credit, the market yields, the maturity length as well as tax status. The price of a municipal bond and its market yield mostly move in different directions. Whenever there is a price increase, there is likely to be a decrease in market yield.
  • There is an interest rate: The bond issuer pays a specified amount of interest to the investor as payment for making use of the money within a specific time frame. The amount to be paid as interest is calculated as a percentage of the investor’s principal accrued bi-annually. The interest rate the issuer is required to pay to the bondholder is determined by prevalent market conditions.
  • There is a yield: yield is the rate at which the investor earns interest on the investment. The rate of return is determined by the price of the bond and the interest rate.
  • Maturity date: each home that is issued has a maturity date. This date refers to the specific time the issuer is expected to repay the investor.
  • Credit evaluation: an investor will be able to evaluate a bond issuer’s credit standing based on its current financial circumstances. Bonds are independently assessed to ascertain if they are creditworthy or not. Through credit rating, investors can determine the probability that the principal and the interest will be paid back within the specified time frame. This credit rating is done by independent credit rating agencies. A lower credit rating implies that there is a high possibility that the principal and interest will not be paid back at the specified period. It is ideal for investors to get a credit report and examine it before investing in bonds.
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Types of municipal bonds

Municipal bonds are issued either as revenue bonds or general obligation bonds.

  • Revenue bonds: this type of bond is backed up by specific projects and not tax collected by the government. The funds are used in funding projects that can generate revenue that will be used in paying back the principal and interest. Sources of revenue bond repayments are fees paid on leases and highway toll fees. If at any point the source of repayment stops generating revenue, the bondholders can not lay claim to the source of revenue.
  • General obligation bonds: This is a municipal bond that is not secured or tied to any assets. The bondholders are paid interest from taxpayer’s money. The backing behind general obligation bonds is the integrity of the issuers.

Why Municipal bonds are a good investment

#1. Tax exemption benefits

The interest that is paid to bondholders is not subject to federal income tax. If the bondholder is resident in the issuing state, the bond is also exempted from local and state taxes.

Bondholders, unlike stockholders, maybe more conservative, aiming to preserve and not necessarily increase wealth. Considering the tax-exempt nature of most bonds, the interest rate may be considerably low.

#2. The low default repayment rate

The possibility of default in repayment is low with munis. These bonds are issued by the government or on behalf of charities. Historically, municipal bonds have maintained a consistent yield over time and can therefore be a trusted source of cash flow.

#3. A lower level of risk

When You compare a municipal bond with other classes of assets, munis are less volatile. This makes bonds a stable investment option and reduces the chances of losing money in the process.

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#4. Provides a predictable cash flow

The interest paid on municipal bonds comes in installments, usually every six months. This makes these bonds a prosecutable source of cash flow. The payments are sent out to bondholders biannually.

How to Invest in Municipal Bonds

To invest in municipal bonds, you have to either buy them directly or invest in municipal bond funds. To buy municipal bonds directly, you may have to buy from the county, city, or state through a local bank or broker.

However, a broader range of investments will bring in more benefits. If that is the case, you may consider going with a municipal bond fund. Another reason you may go for a municipal bond fund is that it is more liquid when compared with an individual bond. So how do you go about getting the bond?

  • Identify the bond you want to invest in: the first step is to find a municipal bond that works for you. At this stage, you will also need to find a brokerage that offers the type of bond you want to invest in.
  • Open an account with a brokerage: Once you have narrowed down your choice of a brokerage, go ahead and open an account. You can either open a taxable or regular brokerage account
  • Place an order: Once you have salt with the account opening process, go ahead and place an order.

How Municipal Bonds Fit in Your Portfolio

Municipal bonds can be a huge asset class to add to your portfolio. This is especially true when you consider the tax advantages associated with it. Notwithstanding that bonds have a lower interest rate, yet they are predictable and can be a good source of steady income.

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If you are starting and are looking for a fast way to grow your investment portfolio and build wealth, you may have to go easy on bonds.

However, if you are nearing retirement and are on the lookout for conservative and reliable ways to preserve your funds while making a little extra on the side, municipal bonds are your best bet.