What Are Municipal Bonds?
These are different than cooperate bonds because they are issued by state and local governments to fund projects. In this article, I am going to explain the municipal bond advantages and risks of purchasing these as an investor. There are a few basics about municipal bonds every investor should learn about.
- Fundamental reasons why governments borrow money
- Risks of default
- Tax Advantages
The Fundamentals of Municipal Bonds
Like, cooperate bonds it is important to understand these at a fundamental level. Cities and States need money to fund projects and they repay them back with tax revenue. Some examples would be schools, highways or recreation centers. Other times these are borrowed in emergency situations to keep a city or state operating and to provide liquidity. The daily operations of a local government might be emergency personal, unexpected projects, or waste management.
The Risks of Buying A Municipal Bond
On the intro page, I go over bond ratings which are actually a good place to start when it comes to researching a municipal bond you would like to purchase. These are rated as an investment or speculative grade which will give you a good starting point for the risks and if it is a suitable bond for your portfolio.
One of the highest risks for this type of bond is “the risk of default.” As I am writing this, I can think of one example of a city that went bankrupt and left investors holding the bag. The City of Detroit is a good example of a recent bankruptcy that happened within the United States. When you look back further into history this was a thriving well-managed city that had new leaders making bad decisions.
Yes, Municipal bonds are tax-exempt at the federal level; however, just because these bonds are tax-free doesn’t mean that they are better for you as an investor because if you are a low-income earner in a low tax bracket you might make more money by purchasing a corporate bond which pays a higher rate of interest. Another important thing to remember is that in some cases you will owe state tax. There is a lot of research that goes into a “tax-free portfolio” and it is important to have a tax professional or do your own research before buying bonds or into a fund.