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What Are Tax Free Municipal Bonds?

What Are Tax Free Municipal Bonds?

As any investor knows, there are a multitude of different types of investment vehicles each with their pluses and minuses and associated levels of risk. Not every investment is appropriate for every investor especially those looking to preserve capital and earn income on a tax-free basis. Roth IRAs are a good way to generate annual income tax-free but require forward thinking and decades of contributions. Another option is to purchase tax-free municipal bonds which are free from state and federal taxes and can provide decent yields to provide additional income. Let's look closer at what a municipal bond is, how it works and how they can be purchased by investors.

What Are Municipal Bonds?

Municipalities such as state and local governments fund improvement projects by one of two ways. They will either use property sales tax revenue or they will issue debt in the form of bonds. When a state or local government raises capital through debt they issue municipal bonds to be sold to individual and institutional investors. As a voter, you may have seen various bond proposals appear on local election ballots for schools and roads. By purchasing a municipal bond, an investor is lending money to the state or city in return for an interest payment. The primary benefit of purchasing municipal bonds is their tax-free status. The federal government, through separations of powers, is unable to tax state projects in much the same way the state is not allowed to tax federal projects. States choose not to tax municipal bond income to incentivize residents to invest in the infrastructure they use on a daily basis.

Three Bond Types

There are three different types of municipal bonds which can be issued by a state or local government. The first type is a general obligation bond and it is backed by the full faith and credit of the municipalities' taxing authority. The second type is a revenue bond which is backed by revenue generated from a specific project like a sports stadium or convention center. The third and final type is an industrial development bond which is issued when building industrial facilities which are subsequently leased to private companies. When an industrial complex is built to attract private businesses, the bond coupon rate is paid from leasing fees.

Purchasing Municipal Bonds

The two primary ways of purchasing municipal bonds is through the use of a broker or by purchasing shares in a municipal bond fund. Purchasing municipal bonds directly usually requires a minimum initial investment of $25,000 since par values come in amounts of $5,000. Municipal bond funds, much like other mutual funds, typically have minimum initial investments of $2,000 which may be waived if the fund allows direct monthly investment withdrawn from a checking account. It is rare but not unheard of to purchase bonds directly from an issuing authority since third parties are normally needed to issue debt in the first place

Municipal Bonds Ratings

Municipal bond ratings are conducted in a similar fashion to bond offerings by the federal government and private corporations. Moodys and Standard & Poors are the two primary bond rating agencies and they provide a bond rating scale using a grading system to assist investors in determining bond quality. Bonds with the highest rating are virtually guaranteed to maintain principal and make coupon payments and are rated AAA. The bond rating scale goes down from there to B's and C's which are considered less secure and a higher risk. Junk bonds of the riskiest and are normally tied to companies with shaky financials and a high likelihood of bankruptcy or insolvency. Municipal bonds, much like government treasuries, are normally considered the safest type of investment and often have the highest bond rating.

Image by: Greg Clarke