We already know that bonds are issued by a wide variety of entities. Bonds are routinely issued by corporations, banks, and even governments all over the world. A special category of bonds called municipal bonds (munis) are issued by various local governments across the globe. These bonds are often categorized separately because they have certain special characteristics. In this article, we will have a closer look at what municipal bonds are as well as the pros and cons of investing in such bonds.
What are Municipal Bonds?
Municipal bonds are IOUs that are commonly issued by local governments. Hence, when investors invest in municipal bonds, they are ideally giving money to local governments to build projects. It is common for municipalities to issue bonds to finance projects such as roadways, railways, and even canals. The market for municipal bonds is fairly large. It has been valued at close to $4 trillion. However, it is important to realize that the number of issuers in municipal bond markets is much large. Hence, there are a lot of issuers that increase the variety in the municipal bond market.
Different Types of Municipal Bonds
There are several types of municipal bonds. However, most investors segregate these bonds into two main categories based on the guarantee that the municipal government is providing. The categorization of municipal bonds has been mentioned below:
- It is possible for the issuer i.e. the municipal body to secure the bond by its ability to tax the people. If the bonds issued are secured by tax dollars, then they are called general obligation bonds. This is because the increased liability becomes a part of the general obligation of the municipal authority. It is possible to further subdivide these types of bonds based on whether the debt will be paid off from existing tax revenues or whether more revenues will have to be raised by levying more taxes.
- It is also possible for municipal authorities to repay the debt by using the revenues generated by the project itself. For instance, if the debt was issued in order to build a road, the proceeds from toll collection can be used to repay the debt. Such bonds are less reliant on the ability of the municipality to tax its residents. Although, almost all municipal bonds have the implicit backing and guarantee of the municipal authority.
Advantages of Municipal Bonds
A large number of municipal bonds are already in circulation. Also, a very large number of bonds is issued every year. This is because of the large investor appetite for such bonds. This appetite is the result of several distinct advantages that such bonds provide. Details about the advantages of municipal bonds have been explained below:
- Tax Advantages: Firstly, since municipal bonds are issued by the governments, they are often given favorable tax treatment. Depending upon the entity issuing the bond, investors may not have to pay state or even federal income tax on the earnings from the bonds. This is quite important since if the investors fall into a higher tax bracket, this tax shield proves to be quite valuable. It is for this reason that a lot of entities as well as high-earning individuals hold municipal bonds. The tax advantage ensures that investors receive a higher net yield irrespective of the yield provided by the marketplace.
- Diversification: The risk profile of municipalities is quite different from corporations as well as financial institutions. Also, municipalities can raise large amounts of money with relative ease if they want to pay back the loans. This is because they are authorized to tax the general population. The different type of risk-return profile means that municipal bonds are a great addition to the overall portfolio of any investor.
- Secure Investments: Since municipal bonds are government entities, they have a very low-risk profile. This means that investors who put their money in municipal bonds feel that there is a very high probability, that the entire fund that they have invested will be returned to them along with interest. The security and predictability of the investment make it a preferred investment choice for investors looking for fixed monthly returns.
Disadvantages of Municipal Bonds
There are certain disadvantages of investing in municipal bonds as well. These disadvantages have been listed below:
- Low Yield: Firstly, municipal bonds have a very low yield. This is because they provide investors with very high security. Hence, municipalities are able to raise money from the market at very low-interest rates. The competition amongst investors lowers the yield considerably. Municipal bonds are known for providing abysmally low yields which barely beat inflation in the long run.
- Less Liquidity: It is also important to know that municipal bonds tend to be less liquid. This is because most investors holding these bonds tend to hold them till maturity. Also, since there are many varieties of municipal bonds, it is difficult to find a counterparty who wants to trade in the exact type of bond which an investor might want to sell. There are certain famous municipalities and counties which have a highly liquid secondary market. However, in most cases, selling a municipal bond can be quite difficult.
- Not Suitable for Retirement Accounts: Municipal bonds are not suitable if the investment is being made for retirement accounts. This is because those accounts already provide tax benefits and hence there is no additional advantage of investing in municipal bonds.
The bottom line is that municipal bonds are safe. However, they provide a very low yield. They are largely used by investors in higher tax brackets who end up getting a better yield because of the tax advantages.
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