Smart Bond Investing—Types of Bonds

Municipal Bonds

 

Municipal securities, or "munis," are bonds issued by states, cities, counties and other governmental entities to raise money to build roads, schools and a host of other projects for the public good.

 

Check out FINRA’s Muni Bond Checklist

 

Munis pay a specified amount of interest (usually semiannually) and return the principal to you on a specific maturity date. Most munis are sold in minimum increments of $5,000 and have maturities that range from short term (2 – 5 years) to very long term (30 years).

 

When considering an investment in municipal bonds, bear in mind that no two municipal bonds are created equal—and carefully evaluate each investment, being sure to obtain up-to-date information about both the bond and its issuer. For more information, see FINRA's Investor Alert Municipal Bonds—Important Considerations for Individual Investors.

 

Thinking about investing in munis? Use this checklist to help avoid common pitfalls of municipal bond investing.

 

Buying and Selling Munis

 

While the muni bond market is active, with a daily trading volume in excess of $10 billion, some bonds are more liquid than others. Some bonds trade actively, while others may have no activity (no interested buyers or sellers) for weeks at a time. As a general category, municipal bonds tend to be more sensitive to forces of supply and demand than other fixed-income categories. This has the net effect of increasing your market risk: If your bond is out of favor with other investors at the time you need to sell, the price you will get for the bond in the secondary market will suffer. And of course, like all bonds, munis are subject to interest rate risk—if rates rise above the rate of your bond, the value of the bond in the secondary market declines.

 

Because of the dizzying number of muni bonds available (virtually no two bonds are alike), and the fierce competition among dealers to gain a piece of the business, you should enter into muni investing with care. Do your homework, starting with the selection of an investment professional with a proven track record of municipal securities expertise.

 

When considering an investment in municipal bonds, bear in mind that no two municipal bonds are created equal—and carefully evaluate each investment, being sure to obtain up-to-date information about both the bond and its issuer.

 

Munis and Taxes

 

The primary reason most individual investors buy municipal bonds is because they afford favorable tax treatment on the interest an investor earns. Interest on the vast majority of municipal bonds is free of federal income tax. Indeed, municipal securities are the ONLY securities for which this is the case.

 

Furthermore, if you live in the state or city issuing the bond, you may also be exempt from state or city taxes on your interest income. Bonds issued by Puerto Rico, Guam and other U.S. territories are tax-exempt for residents of all states.

 

Not all municipal bonds are free from federal tax. Taxable municipal bonds may be issued to finance projects that the federal government won't subsidize. To compensate investors for their lack of a tax break, these bonds tend to offer yields higher than tax-exempt municipal bonds, and more in line with rates of corporate or agency bonds.

 

AMT Awareness

The alternative minimum tax (AMT) is a tax some people have to pay. The AMT is figured by a different set of rules than your normal income tax computation, but whichever computation comes out higher is the one you have to pay. Investors who purchase "private activity" bonds—bonds that are not exclusively used for government functions—may be subject to the AMT. Unlike other municipal bonds—including 501(c)(3) private activity bonds—interest earned on these "private activity bonds" cannot be deducted according to AMT rules and may trigger an AMT payment. A responsible financial professional should evaluate your AMT liability before recommending a tax-exempt investment. You should also seek the advice of a tax professional.

 

 

Muni Bond Risk Report Card

  Green Checkmark Credit and default risk can vary greatly from bond to bond. Insured bonds help offset this risk.
  Green Checkmark Call risk exists, not just for investors who buy bonds at issue, but also for those who may have paid a premium for the bond in the secondary market, where it was priced as if it would not be called. Should such a premium-priced bond in fact be called, its value would drop.
  Green Checkmark Interest rate risk: If interest rates rise, the value of a municipal on the secondary market will likely fall.
  Green Checkmark Liquidity risk: Some munis are more liquid than others.

 

 

Municipal Securities Snapshot

  Issuer States, cities, counties and other governmental entities
  Minimum Investment Generally $5,000
  Interest Payment Fixed, floating/variable and zero-coupon; interest is paid semiannually for fixed-coupon security.
  How to Buy/Sell Through a broker
  Bond Interest Rate Determined at origination, varies by bond
  Price Information Municipal Bonds: FINRA Market Data—Bonds
  Website for More Info MSRB

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