5 Things you Need to Know About Municipal Bonds

Tuesday, 01 Feb 2011 02:51 PM

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Who issues municipal bonds? Why are they issued?
Municipal bonds are debts raised by states, cities, counties, and other government entities. They use the money raised from municipal bonds to build schools, highways, hospitals, sewer systems, and many other projects of use to the public. So, if you are purchasing or investing in a municipal bond, you are lending to these government or quasi-governmental entities. The entities pay you interest at a specified rate, usually at half-yearly intervals, and return the principal (your investment in the municipal bond) upon the municipal bond maturity.

Taxable and tax-exempt municipal bonds.
Municipal bonds can either be taxable or exempt from tax. The advantage of investing in municipal bonds is that the interest income is free of federal income tax and state income taxes, providing you live in the state where the bond is issued. Some states may exempt only a few bonds from taxes and tax the remaining municipal bonds.

How to buy Municipal Bonds.
Individuals can buy or invest in municipal bonds when the bonds are originally issued (called buying in the primary market). Or they can buy them in the secondary market (after the bonds have been issued). After deciding on the market you want to buy the municipal bonds from (primary or secondary), call a dealer or banker, who is registered with the Municipal Securities Rule-Making Board. Municipal bonds are sold and traded by dealers in the OTC, or over-the-counter market (this means that they are not exchange-traded).

What do you need to do before buying municipal bonds?
  • Collect a prospectus or offering statement about the municipal bond you want to buy or invest in.
  • Understand the risk, return, and other terms and conditions associated with the municipal bond.
  • Estimate the tax benefit your investment in the municipal bond will generate.
  • After all of this, if satisfied, you can ask the broker to invest.
  • Remember, you do not have to pay any commission to the dealer when investing in municipal bonds.
Zero coupon municipal bonds.
Zero coupon municipal bonds are sold at a discount of the face value. These bonds do not generate any interest for the investor. The investor receives just one lump sum payment upon the bond’s maturity. The payment represents the principal (money invested) and the interest realized on the investment. The difference between the money invested originally and the payment received upon maturity is considered the interest. These are often available at deep discounts to the face value.

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