What You Should Know Before Investing in Municipal Bonds

What You Should Know Before Investing in Municipal Bonds

When considering investing money in municipal bonds, you will want to know what you are getting into. Here are six things you should definitely know before you invest in municipal bonds.

Who does the issuing? The government issues municipal bonds. It may be done at the city, county, or state level. The money received for the bond is used to construct public structures, such as hospitals, highways, and schools. The government will then pay you an interest based on a specified rate.

Tax freedom. The interest on municipal bonds is generally exempt from federal income tax. Interest may also be exempt from state and local taxes if you live in the state where the bond is issued. Due to the tax benefits, the interest rate for municipal bonds is usually lower than on taxable fixed-income securities such as corporate bonds.

What is required? While you do not have to pay the dealer commission when investing, you will need to collect statements. After you have read the terms and conditions, and you understand both the risk and the return rate, you can call the broker. Many will contact a tax preparer to evaluate their tax benefits prior to purchasing.

Know about liquidity risks. This refers to the risk that investors will not find an active market for the municipal bond. This could prevent investors from buying or selling when they want and obtaining a certain price for the bond. Since many investors hold municipal bonds instead of trading them, the market for a particular bond may not be that liquid and quoted prices for the same bond may be different.

Be aware of credit risk. This is the risk that the bond issuer may undergo financial difficulties that would make it hard or impossible to pay interest and principal in full. Credit ratings seek to estimate the relative credit risk of a bond as compared with other bonds, although a high rating does not reflect a prediction that the bond has no chance of defaulting.

Be aware of inflation risk. Inflation is a general rise in prices, and it reduces purchasing power. This is a risk for investors receiving a fixed interest rate. Consequently, it also can result in higher interest rates and, therefore, lower market value for existing bonds.