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By: Wilmington Trust
Municipal bonds are well suited for investors seeking regular interest payments, especially those in higher income tax brackets. "Munis" typically provide tax-free investment income, and there are usually additional tax savings if you buy bonds issued by your home state. And municipal bond mutual funds often require a smaller initial investment than individual bonds.
As with any investment, there are several considerations to be made before you invest in municipal bonds. Your tax situation, the various types of bonds that are available, and the inherent risks should all be analyzed. The following is a general overview to help you address these issues.
What are Municipal Bonds?
Simply put, when you buy a municipal bond, you are lending money to an entity - often a city, town or school district - that, in turn, promises to make interest payments to you on a regular basis and then repay the entire principal on a specific future date. Municipal bonds are debt obligations issued by states, their political subdivisions and certain government agencies and authorities. The municipal securities market, which enables governmental entities to raise money for various public purposes, currently consists of over 50,000 issuers.
Short-term notes are typically sold in anticipation of the receipt of future funds, such as taxes. These notes allow municipalities to cover seasonal and temporary imbalances in money flows. They generally mature within one year. Longer-term bonds, with maturities greater than one year, are typically issued to finance capital projects, such as schools and roads, as well as budget deficits.
Under present federal law, the interest income from municipal notes and bonds is generally exempt from federal income taxes. In most states, the interest income received from municipal securities issued by governmental units of that state also may be exempt from state and local income taxes. This tax exemption allows states and local governments to borrow money at lower interest rates while providing investors with a real tax advantage.
Types of Municipal Bonds
There are two basic types of municipal bonds: general obligation bonds, or G.O.s, and revenue bonds. General obligation bonds secure the payment of interest and principal by the full faith and credit and taxing power of the issuer. These types of bonds are also voter-approved. Revenue bonds, on the other hand, secure the payment of interest and principal by the revenue flow of the project or facility that was built with the proceeds of the bond issue. Examples of projects funded by revenue bonds include airports, bridges/tunnels, toll roads, water and sewer systems, hospitals, housing projects, and colleges and universities.
Municipal bonds that are classified as general obligations or revenues can also carry other features, such as variable or floating interest rates, zero-coupon interest rates, refunded dates and prices, and call dates prior to maturity. Insurance is another common feature that exists for municipal bonds. The insurer promises to pay interest and principal, when it comes due on the bond, if the issuer should default. Prior to 2008, bond insurance was very prevalent because it was an inexpensive way for an issuer to take a bond's rating to AAA (for most bond insurers). In fact, over half of all bonds issued opted to use bond insurance. More recently, bond insurance has been used on less than 10% of bonds issued, as most insurers lost their AAA ratings, due to their involvement in the subprime and CDO markets. There are currently no municipal bond insurers that Moody's rates AAA, while there is one - Assured Gty, FSA, and BHAC - that Standard & Poor'sŪ rates AAA.
Understanding Municipal Bond Safety
Before buying a municipal bond, you should understand the risk that is being assumed. Most municipal bonds carry a rating from one or both of the two major bond rating agencies, Moody's and S&P. Generally, bonds that are rated BBB or better by Moody's and/or Baa or better by S&P are considered "Investment Grade." Bonds that do not carry a rating are considered "non-rated" in the marketplace.
Bond ratings can be used as an initial parameter of an issuer's ability to repay the bond's face value at maturity. But this should not be the only checkpoint made prior to purchasing a bond. You should also review the financial condition of the issuing entity by requesting an "official statement" on new bonds that are being brought to market, or request current financial statements for bonds that are being sold in the secondary market.
Understanding Market or Interest-Rate Risk
Municipal bonds, like Treasury and corporate bonds, are priced based on par, or $100. This is the price that the issuer agrees to pay at maturity. Market conditions will shift the price of bonds; as interest rates rise, the price of a bond will fall and vice versa. This is known as market risk.
For an investor who plans to hold a bond to maturity, the change in the bond price before maturity is not a concern. But if you needed to sell the bond before maturity, you may incur a capital loss or a capital gain as a result of a shift in the bond's price.
When purchasing bonds, there are different types of yields that can be quoted, and it is important to understand what each represents.
Current Yield: This is the annual return on the dollar amount paid for a bond. The formula used to calculate current yield is: Coupon/Price. It is important to note that this calculation is limited by the fact that the price on the bond will move to 100 as the bond gets closer to maturity. Current yield doesn't reflect any gain or loss as the price moves to 100. Therefore, a better calculation to determine the actual return on a bond is yield to maturity or yield to call.
Yield to Maturity: This is the total return you receive by holding a bond until it matures. It equals the interest you receive from the time you purchase the bond until maturity, plus any gain or loss. It assumes that the coupon payments can be reinvested at the computed yield to maturity.
Yield to Call or Put Date: Many bond issues allow the issuer to call all or a portion of the bonds at a premium, or at par, before maturity. When buying bonds, be sure to ask about call provisions. Typically, when purchasing a callable bond at a premium, the yield to call will be quoted along with the yield to maturity when the yield to call is lower. The yield to call is calculated using the same assumptions as the yield to maturity, but the yield to call assumes that the bonds will only be held to the call date.
Municipal bonds can offer a host of benefits to investors who wish to maximize after-tax rates of return with high-quality securities. But municipal bonds can present problems if investors do not understand the risks associated with the purchase and sale of these securities. Whether you purchase individual bonds or municipal bond mutual funds, it is best to consult a tax and/or investment professional to assist you in making the right choices for your investment portfolio.
Standard & Poor's 500 is a registered trademark of Standard & Poor's Corporation, a division of The McGraw-Hill Companies, Inc.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.