Financial Information: What Is A Tax Free Municipal Bond?

Are muni bonds for you? This article explains the pros and cons of this tax-free investment vehicle.

Bonds are basically IOUs with interest. When you buy a bond, you buy an indebtedness that produces income and (hopefully) is paid in full in the end. There are many variations on the specifics, but as an individual investor it's enough to know that you're lending money to a corporation, organization or government. This is different from stocks since you don't own any piece of the company (or whatever); you merely have a monetary claim against them, just like your mortgage lender has a claim on you to repay their loan.

Most bonds are generally viewed as a safer option than stocks, but there are a few key factors of importance to consider when buying bonds. One of them is the interest rate; if the market rate go up, a bondholder's investment is worth less, and vice versa. Another factor is length of time to maturity, as a long-term bond is more sensitive to interest rate swings - for good and for bad - compared to short-term bonds.

But perhaps the most important factor is WHOM you're buying bonds from. Large, solid companies and small, troubled companies alike offer bonds, but the latter offer much better returns since the risk of default is higher. In other words, you get rewarded for taking on risk, but you also stand to lose it all if the company goes belly-up.

On the other side of the risk spectrum is Treasuries. Few believe Uncle Sam will declare bankruptcy anytime soon, so the risk is very low. Hence, the return is lower. Municipal bonds land just about in-between corporations in terms of risk and come with the added kicker of being tax-free.

Munis, as they're called, are bonds issued by local governments. These are exempt from federal tax and often state/local taxes as an incentive to get investors on the hook. For example, say you're in the 28% tax bracket. A taxable bond paying 6% yields an after-tax return of just 4.32%. This is why a tax-free muni bond paying 5% may seem like a loser at first glance, but as you see in the calculation above, the take-home returns of the muni can be a lot better.

This is obviously more attractive the higher your tax bracket. In other words, if you're paying 15% tax, you're getting much less benefit from the tax-exempt status than someone in the 30+ range.

Then there's issue of risk. As mentioned earlier, local governments issue these bonds, and they may be less robust than we'd like to assume. As you may recall, bond investors lost a whopping $1.7 billion when California's Orange County declared bankruptcy in the early 1990s. Needless to say, it is prudent to check the credit worthiness before buying bonds from any government agency.

Still, bear in mind that muni defaults are very rare. The Public Securities Association, an industry trade group, puts the default rate at just 0.5% of all munis since 1940. Compared to many other investments, this is not exactly risky. So who invest in munis? If you're in a high tax bracket, live in a state with high income tax, and believe the interest rates will remain flat or decline over the next few years, munis can be a great investment. If none of this applies, you may be better off with other investment vehicles.

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