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By Jon Elton
Municipal bonds are the informal debt instruments issued by county, state and city governments, to raise money for the community projects such as hospital, new school or a highway. The main feature of municipal bonds as a form of investment is that, the interest paid to the municipal bond owner is federal tax exempted. In addition, investors are exempted from state taxes in case they reside in the same state of issuance of municipal bonds.
Usually, there are two forms of investment in these. The first is termed as general obligation. This depends on the issuer’s ability to tax and issued for payment of projects such as sewer systems and schools. Majority of investors feel that general obligation bonds are much safer as compared to their counterparts in the revenue section. However, this is a misconception.
On the other hand, the local government sanctioned entities or special state government entities issue the revenue municipal bonds.
With the revenue generated from business backing the obligation, investors stand to gain from the interest. In case of water firms, bondholders get cash payment from the amount generated by the customers who pay their water bills.
Taxable Municipal Bonds V/s Tax – Free Municipal Bonds:
Investors having an average interest in bonds may have a difficult time in deciding between tax-free municipal bonds and taxable corporate bonds. With the help of a formula known as taxable yield, investors can decide on the type of fixed income investment that may provide them with greatest after-tax return.
Below mentioned are the two major thumb rules beneficial for amateur municipal bond investors:-
– Non-profitable organizations are always at an advantage in investing in the corporate bonds largely because of their tax-free status.
– Investors, who come under the high income tax brackets, are usually better in investing in tax-free municipal bonds.
Safety of Municipal Bonds:
In relation to the individual municipal bonds, very little information is available. This forces the investors to depend heavily on Bond Credit Ratings
that credit agencies assign.
In order to ensure the safety of their investments, bondholders need to find out the following:-
– The responsible authorities for servicing of interest payments on bonds.
– Check for the financial status of the issuer.
Investors need to ask themselves, as to whether the place where they are investing is a promising community with a high net worth having growing citizen base, or a degenerating metropolis having low-income demographics.
In the security analysis of 1942, Benjamin Graham mentioned the below listed characteristics of municipal bonds:-
– Has a population of at least 10,000 or greater.
– Diverse economy and,
– It bears a good record of punctual payments on the previous obligations.
As compared to the high-risk private bonds, investment in government bonds is the best risk free option. There is no wonder that conservative people still opt for them as a risk free form of investment.
Investment in municipal bonds yields double benefit to the investor. The first one is that, the investor gets to invest in public development projects and the second benefit is that, it comes with a small smart gain for the investor.