Municipal bonds are issued by local and state government that generate a tax free income. When you buy a municipal bond you loan a sum of money to the issuer who promises to return your invested money back to you along with the interest at a specified period of time. You get your investment back when the bond reaches its maturity date. These bonds are used to raise money for many projects like schools, hospitals and highways.
Municipal bonds attract the investors since they are exempt from federal tax. It is also exempt from state taxes if it is purchased from the same state. The interest rate on municipal bonds is fixed and it remains unchanged over the life of the bond. But the interest rates paid by the municipal bonds are lower than that of corporate bonds.
The investors with lower tax bracket do not benefit much from these bonds. A good idea is to buy a municipal bond that provides high interest rate and keep it till the time it matures. Municipal bonds are considered to be a safer option than the corporate bonds since the there is a least possibility of local government to go bankrupt than a corporation.
Due to the tax benefits and safety of municipal bonds it has lower yield compared to the corporate bonds. Municipal bonds are categorized into two types namely general obligation bonds and revenue bonds.
General obligation bonds are not secure and are backed by the full credit and faith of the municipality. They are issued in order to raise the funds for projects such as schools and sewer systems. They usually come with low interest rates. They are low risk investments since they are supported by the full credit of the municipality. In order to make up for its low interest rates these bonds offer free federal income taxes. These bonds serve as a useful tool for the municipalities for the purpose of raising funds.
Revenue bonds are given out by some special agencies. These bonds involve more risk than the general obligation bonds since the returns of the bonds solely depend on the revenue created by the project. The income that is generated from these projects is used to pay back the investor.
The interest risks of municipal bonds depend upon the rating risks of the agency that gives out the bond. Municipal bonds that hold high interests have high yields. Likewise municipal bonds with low interests have low yields.
Capital gains that occur from the municipal bonds is sold when the bond is matured and they are not exempt from taxes. Municipal bonds are subject to the AMT i.e Alternative Minimum Tax. The municipal bond which is subject to AMT is the one that includes public and private partnership for something for instance a sports stadium. Due to the tax exempt status of the municipal bonds they are generally preferred over other types of bonds.