Are Municipal Bonds Right For You?

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When deciding on the right investments for your portfolio you might want to consider adding municipal bonds to the mix. Muni bonds, or muni’s as they are referred to by market insiders, aren’t for everyone so as with all other investments it is important to do your homework and find out all of the particulars that go along with investing in municipal bonds before shelling out your hard earned income on a financial product that doesn’t make sense for you.

Muni Bond Particulars

Like any other interest bearing security, municipal bonds are in their most basic form an IOU issued by a particular entity in order to raise capital. In the case of muni bonds that entity is usually an American city, local government or and agency of a local government. For example, you will find that most cities around the country issue bonds in order to raise funds for any number of reasons, but mostly as a means to supplement the city budget or for their cash management. You are probably also familiar with muni bonds issued by city agencies to fund specific projects such as road building, water treatment facilities, and other large scale projects that require large amounts of capital not included in the city budget. Muni bonds are a great vehicle for local governments to use to fund these infrastructure type projects and most if not all American cities have been taking advantage of this market for quite some time.  

One of the most important and distinctive aspects of a municipal bond versus other similar financial products is that in most cases the interest that you earn on investing in municipal bonds will be tax free, meaning that you will not have to show the interest income earned from investing in muni bonds as income on your federal or state tax return. This is extremely important for anyone who wants to earn tax free income, or as is the case with many wealthy investors, those who need tax shelters or investments in products that can reduce their overall income tax burden.

All Muni’s Are Not Created Equal

Within the heading “Municipal Bonds” there are several different types of muni bonds that you should be familiar with if you are considering this investment product. As with federal or U.S. Treasury securities, local governments such as The City of New York and their affiliated agencies will issue these securities with various maturity dates attached to them. Shorter term muni paper, that which matures in one year or less is called municipal notes while the longer dated version of these securities are called municipal bonds and they can mature anytime after one year depending on how the particular city or agency has structured the issue. The two main types of muni bonds are general obligation bonds and revenue bonds. General obligation bonds are the ones that you might be familiar with as these represent city expenditures that have to be approved by the voters. This is due to the fact that general obligation muni bonds are backed by the full faith and credit of the city government issuing them. Another way of saying it is that the taxpayers of city issuing these bonds agree to pay the holders of these securities and that tax revenues will be committed to do so. On the other hand, the underlying backing for revenue bonds comes from, yes you guessed it, revenue. Those investors holding revenue muni bonds can expect to be paid back from the money a city or city agency collects from tolls, or any other income from the project being funded by the bond. The most common projects associated with revenue bonds are toll roads, bridges, airports, water and sewerage treatment plants, hospitals, and various local housing projects.

Municipal Bond Returns

It is important at this point to note that the tax-free status of the income derived from investing in municipal bounds sounds like a very attractive deal for anyone interested in these investments. After all, who wouldn’t like to earn tax-free income? And on top of the tax-free status of muni investment income, another very good reason to consider adding them to your investment portfolio is that they are very secure, low risk investments. This is not to say no, risk, just low risk. Now comes the “But”…..but, bear in mind that because muni investment income is tax free and they are a low risk investment, they are also a very low return investment. You won’t get rich investing in municipal bonds. However, comparing a muni bond that pays you 2% to a corporate bond that pays you 5% is not fair or accurate in that your higher return from the corporate bond has to consider the tax implications, and higher risk associated with these bonds versus muni bonds.

To Buy Or Not To Buy

Muni bonds are a good investment for those people looking to park away some money into a risk security for which they won’t have to pay taxes. You generally find older investors who are close to retirement age parking funds in municipal bonds because the market for them is very liquid, meaning that you can cash out whenever you want and you don’t risk losing too much of your initial investment with them; both very important considerations for anyone that is close to putting their feet up after a long hard career. Extremely wealthy individuals are also good candidates for muni bonds due to the tax free nature of the income derived from them.

My take: Muni bonds aren’t the sexiest investment out there because they pay a very low rate of return. But far too often, especially among those not well-versed enough to know better, it is always a good idea to devote a portion of your investments to relatively safe, albeit low yield investments. The one thing that I would urge in this regard is that if you are investing in a safe investment product, just make sure that it is a very liquid product so that you can quickly cash out in order to devote the funds in these products for other investments should another opportunity come along that you would like to investigate. Liquidity is a benefit that should not be underestimated.

 

 

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