How Do Municipal Bonds Work

Municipal bonds that are also known as debt obligations are issued by various entities such as the municipalities. Like any other bond when you buy municipal bonds you loan your money to the issuer. The issuer will then make the interest payments in accordance with the rates that are agreed upon until the maturity date.


The state or local government that issue the municipal bonds sell the bonds to the investors while issuing them. The issuer promises to pay back to the investor at a certain date with interest. Until the bond matures the bond holder receives the periodic interest payments. The interest is tax exempt depending on the type of project that is funded. The municipal bonds are usually issued by the local agencies in order to raise the capital.


There are two main types of municipal bonds namely General obligation bond and Revenue bond.


General obligation bonds are the bonds that are issued with the aim of raising the capital. These are the safest municipal bonds since they come with government backing. No matter what happens the government promises to pay back the bond holder. They mostly come with low interest rates.


Revenue bonds are generally issued by some special agencies. These bonds are riskier than the general obligation bonds since the returns of these bonds depend upon the revenue that is generated from the project. The income that is received from these projects is used to repay the investor.


Because of the tax exempt status of the municipal bond it is preferred over other bonds. Some people feel that these bonds are risk free. While these bonds do have less risk but they are certainly not risk free. The risks associated with purchasing municipal bonds are interest rate risk, market risk, call risk and credit risk. The safety of the bond depends upon its rating.


The bonds that receive a better rating from the risk rating agency are considered to be a safe investment. While the bonds that receive AAA ratings are generally fully insured by the risk rating agency. These bonds make periodic investments to the bond holder.


The interest risks are based upon the ratings risks of the agency that issues the bond. Generally municipal bond with high interests has high yields. Likewise bonds with lower interests have low yields.


One of the highest risk bond is the zero coupon municipal bond where the investor receives the payment only a single time before the maturity of the bond.


The income that is created on the purchase of the municipal bonds can be exempt from the state, local income taxes or the federal that depends upon the purpose of the bond. The bonds that are issued for the purpose of projects are meant for the common goods and are categorized as tax exempt. The bonds that are used to fund the projects are meant for the private parties that are not classified as tax exempt.


Municipal bonds can be obtained from a security firm that is registered with MSRB i.e Municipal Securities Rulemaking Board.

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