A municipal bond is a bond issued by a local government agency, usually to finance projects like construction of a school, improvement of a sewer system, etc. Municipal bonds are unique in that their interest is free of federal income taxes. They are often termed tax-free bonds. A mutual fund that invests in these bonds is often called a tax-free bond fund.
Regulations vary, but interest may also be free of state income taxes in the state where the bonds are issued. Such bonds are said to be double tax free. Some localities also have local income or earnings taxes. Certain municipal bonds may also be exempt from those taxes. They are termed a triple tax free bond.
Like other bonds, municipal bonds are offered by most brokerage firms through their bond desk. Municipal bonds for entities in your area also are often sold through local or regional banks. Muni bonds, like others, are rated by bond rating agencies including Standard & Poor's, Moody's, and Fitch. Investment grade bonds are rated AAA through BBB-. A lower rated bonds is considered a junk bond. Insured bonds are also available, but most such bonds are not insured.
Most municipal bonds are supported by the ability of the issuing agency to tax. They are safer than other bonds because the issuing agency likely will continue to exist and usually can be compelled to pay in time. However, some bonds are revenue bonds and some have been issued at times to support redevelopment projects. Their payments can depend on the success of the project being financed.
For diversification, most investors should buy bonds in $5,000 increments and own at least five issues. Hence, bonds themselves should be considered by those with a minimum of $25,000 to invest. Smaller investors should buy bond funds instead.
Investors should consider their marginal tax rate when deciding whether to invest in municipal bonds. Usually an investor needs to be in the 25% or higher federal income tax bracket to find muni bond yields attractive compared to the interest rates paid by corporate bonds of similar ratings and after those taxes are paid. If the ratings are the same and yields are the same, most investors will choose the muni bond for their greater safety.
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