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Essentially, an investor would be loaning money to the local government in exchange for interest payments over a pre-determined period of time, and at maturity the investor would receive their investment back. In terms of risk, they involve more risk than Treasury bonds, but less risk than corporate bonds. They are particularly good for investors seeking high current income exempt from federal income tax and the preservation of capital.
Be sure to also see the 25 Tips Every Mutual Fund Investor Should Know.
See also our Beginner’s Guide to Bond Mutual Funds.
Investors may ask then when is a good time to buy into municipal bonds? A good time can be if you expect interest rates to decrease in the future (locking in the interest rate and increasing the value of the bond if you choose to resell). A good time to get out, on the other hand, can be if you expect interest rates to increase, or if you are concerned about the financial health of the issuer.
General Obligation Bonds
These are issued by government entities and are not backed by revenues from a specific project or source. They are instead backed by dedicated taxes on real property and, depending on the situation, other taxes. Other general obligation bonds are often referred to as backed by the “full faith and credit” of the government.
These municipal bonds are backed by revenues from a specific project or source.
Both types are tax exempt and are particularly attractive to investors seeking capital preservation.
This is the risk that the issuer cannot meet its financial obligations, like what happened with Detroit. It’s rare for a municipality to default but it can occur. To aid in the evaluation of a lender’s creditworthiness, rating agencies such as S&P and Moody’s rate their debt obligations.
The risk that interest rates will rise causing the bond you own to be paying a lower yield than the market and thus losing out due to the opportunity cost.
Call risk is the risk that the lender will pay back its debt prior to maturity. This can be unexpected and would mean the end of the income stream sooner than desired. Usually there is a premium paid to the investor for the early debt retirement.
Market risk is not applicable if holding the municipal bond to maturity, but if an investor chooses to sell before maturity, whether interest rates have increased or decreased will affect the market price of the municipal bond.
Another thing to consider is capital gains and losses. If an investor holds a municipal bond and interest rates drop and the bond price increases resulting in a capital gain, and an investor resells the bond, then the capital gains will still be taxed at the federal level. Just remember that the interest income stream is tax free, not the capital gains. Capital gains are not a concern if the municipal bond is held to maturity.
High Yield Muni: T. Rowe Price Tax Free High Yield Fund (PRFHX)
Summary: High-yield portfolios invest at least 50% of assets in high-income municipal securities that are not rated by a major agency. The fund buys junk bonds (non-investment grade) and may buy them in default as long as they do not exceed 10% of the fund’s total assets.
Muni California Intermediate: Vanguard California Intermediate Term Tax Exempt Fund (VCAIX)
Summary: Muni California intermediate/short portfolios invest at least 80% of assets in California municipal debt. Because the income from these bonds is generally free from federal taxes and California state taxes, these portfolios are most appealing to residents of California. Duration is less than 12 years.
Muni National Long: Vanguard Long-Term Exempt Fund (VWLTX)
Summary: Muni national long portfolios invest in bonds issued by various state and local governments to fund public projects. The income from these bonds is generally tax -free from federal taxes. Duration is more than 12 years.
Muni New York Long: Vanguard New York Long Term Tax Exempt Fund (VNYTX)
Summary: The fund invests primarily in high-quality municipal bonds issued by New York state and local governments, as well as by regional governmental and public financing authorities. Because the income from these bonds is generally free from federal taxes and New York state taxes, these portfolios are most appealing to residents of New York.
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