Municipal Bond Basics

Financial experts say that if your ultimate investment goal is to create an income of tax-free earnings, then municipal bonds are worth considering. These types of bonds, also called munis, are debt obligations issued by governments. Basically the money you spend on buying the bond is a loan to the municipal issuer. The issuer is required to provide the investor with a specified number of interest payments over a period that has been predetermined. When that predetermined period ends, the bond reaches what's referred to as its maturity date. At this time, you get back the entire amount of money you originally invested.

There are two types of municipal bonds: revenue bonds and general obligation bonds.

Revenue Bonds

This type of bond is when a municipal entity wishes to come up with money for a specific project. Examples of specific projects include a local stadium, a toll bridge, or a highway. The income generated from the sale of revenue bonds is normally used to fund infrastructure projects. This type of bond is tax exempt and low risk. Investors can be comfortable knowing that the likelihood of the issuer paying of the debts is very high.

General Obligation Bonds

Issuers sell these types of bonds when they're looking to raise immediate money to cover expenses. No assets are used as collateral and investors can expect to be paid back through taxes paid or specific revenue from a project. General obligation bonds are also low risk and tax exempt.

Make Them Work for You

To make the most money off of a municipal bond, it's ideal to buy the bond when they're offered with an attractive interest rate. Don't cash the bond in before its maturity otherwise you could lose potential profits. You may also need to pay a penalty.

As you become more comfortable buying bonds, and depending on which stage you are in your life from an investment perspective, you may want to consider buying a series of bonds at one time. They need to be selected carefully and each should have a different interest rate and maturity rate. When one bond matures, the money is reinvested in a new bond. This process is referred to as creating a municipal bond ladder.

The Risks

Municipal bonds are low risk, but they're not risk-free. There is always the chance that the issuer might not be able to pay of the debts and can't pay the schedule interest or return the full amount of your investment. To reduce this risk, evaluate the issuers' creditworthiness. The most creditworthy issuers have a rating of AAA; the least creditworthy have a rating of DDD or D for in default. Many municipal bonds have insurance policies which guarantee payment if default were to occur.

Other risks include a fixed interest rate that doesn't go up even if interest rates in the marketplace rise and tax bracket changes resulting in a significant drop in the marginal income-tax rate.