Municipal bonds are debt obligations issued by government departments, states, or cities to raise money for undertaking public development works such as the building of schools, highways, or hospitals.
Municipal bonds are available in both taxable and tax-exempt formats. However, the most popular municipal bonds are those exempt from federal taxes and, in many cases, state and local income tax.
When buying municipal bonds, one needs to consider the effective yield from these tax-free bonds. Yield from municipal bonds is usually less than the yield one can get from taxable bonds of similar maturities. However, as one doe not pay tax on income from municipal bonds, one’s actual net yield can be higher than the taxable yield received from the corresponding corporate bonds.
Check Issuer’s Financial Condition and Rating:
When buying municipal bonds, one has to figure out if the issuer is likely to be able to meet its financial obligations, make scheduled interest payments, and repay the principal upon maturity. To do this, check the financial condition of the issuers through their official statements or offering circulars.
One can also buy bonds based on the ratings given to them by agencies such as Moody's Investors Service and Standard & Poor's. The agencies analyze the issuer's creditworthiness and their ability to meet the debt obligations. Thereafter, they give the issuers ratings ranging from "Aaa" or "AAA" for the most creditworthy issuers to "Ca," "C," "D," "DDD," "DD" or "D" for those in default.
Another basic strategy for investing in municipal bonds is to purchase a bond with an attractive interest rate, or yield, and hold it until it matures.
One can also invest in municipal bonds by creating a bond ladder. This simply means buying a series of bonds, each with a different interest rate and maturity date. As each bond matures, the principal can be reinvested into a new bond. This simple device minimizes the interest risk associated with bond investing and manages the cash flow from the investment.
Municipal bonds can also be bought locally. Since bonds issued by one state are free of local as well as federal taxes, this makes single-state municipal bond funds especially attractive for high earners in high-tax states. Nevertheless, one should always consider the particular state’s financial situation before buying these single-state municipal bonds.
Zero Coupon Bonds:
Buying Zero Coupon Bonds is another option. However, you will have to exercise a bit of caution in this case, as zero coupon bonds have no periodic interest payments. The zero coupon bonds provide one lump sum payment at the time of maturity, which equals the principal invested and the interest earned, compounded semi-annually. The advantage of these bonds is that zero coupon bonds are sold at a substantial discount from their face amount. Like regular bonds, zero coupon bonds are great for targeting a possible financial need that is likely to arise in the future — for example, a child’s college education or retirement.
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