The Tax Benefits of Municipal Bonds

Today, the most popular investments are municipal bonds. The advantages are wide-ranging, as they offer the potential investor an attractive current income. This is enhanced even more by the fact that some municipal bonds are completely free from federal, local and state taxes.

The investor will also receive a high-degree of safety – with regards to repaying the interest, and also repayment of the principal dependable income.  Other advantages of municipal bonds are a wide-range of choices to suit you [choices that will fit in with your investment quality]. Maturity, type of bond, and geographical location and marketability – in the event that you have to sell before maturity.

As stated above, there are many municipal bonds that are tax-free. Obviously this makes them very attractive indeed to the potential investor. Because they are low-risk but will pay back a reasonable sum of money [which is why they are so popular as an investment] people will continue to look at them as a serious investment option.  Banks, insurance companies, money-market funds, mutual funds are all buying municipal bonds. This is simply because the advantages far outweigh the negatives in this type of investment.

State and local government in the United States issue municipal bonds in order to raise much-needed funds. Muncipal bonds are, in fact, essential to maintaining the cash flow for smaller government entitites. One must remember that because many municipal bonds are tax-exempt, they will also carry a lower interest rate too. You must weigh this up if you are thinking about investing in municipal bonds. However, many potential investors in municipal bonds are willing to accept the low interest rates because of their yield.

The municipal bond market works by an issuer who will sell their debt to investors -with a promise to pay back the loan, plus an agreed upon interest rate. However, with revenue bonds, repayments are linked to the revenue of whatever the bond was used for. Again, you must remember that other municipal bonds are far more secure, as they are backed with property tax revenue – or are considered as general obligation. This simply means that the government entity linked to it has committed to its investment. 

With municipal bonds, the more secure they are the lower their interest rates will be. The investor has two choices here in this circumstance, they can either hold onto their bond [ in order to collect interest payments] or they can re-sell their bond to another investor.  However, one must always realize that municipal bonds do carry risks – with the exception of highly-secure government bonds that are issued by national governments. National governments have the power to print money and on top of that, to affect the  foreign exchange rate too. This is to assure payments – if smaller government entities do not.

Still, issuers of these debts [also called semi-sovereigns] must have excellent credit to continue operating.  A government would not think about defaulting on their obligations –  unless of course, the circumstances where extreme.  Even if they cannot print money, governments would simply raise taxes to cover the costs.

What is risky for investors though are revenue bonds. They do not require an entire local government to fail but rather, the expected income from toll roads or sewer plants. But again, if investor confidence fails, and begins to lower, then any municipal bond – even a general obligation bond – can become a risky investment if it has to be re-sold. Finding a buyer in such circumstances, who will pay full price, may be difficult.  Again, in such a scenario, holding onto a general obligation bond is often the best course of action you can take.

Investors are attracted very much to municipal bonds because of their low risks and tax-free nature – despite the low interest rates too. However, one must remember that today, there is a growing number of taxable bonds.  When local government need a loan, but the federal government will not subsidize the financing, then taxable municipal bonds are issued.  Whether taxable or tax-free, the municipal bond market offers a unique  type of investment that should be looked at very carefully indeed.