How Do Tax-Free Municipal Bonds Work?
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What Is a Municipal Bond?
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Municipal bond issues are among the safest and highest-quality investments available to the investing public. Municipal bonds are issued in level debt amounts so that there are bonds of almost every maturity reaching out to 30 years. Municipal bonds offer yields that are exempt from federal tax, and depending on state and local law, they may be exempt from city, state and local taxation as well. Municipal bonds have low default rates and rank below United States Treasury issues but above corporate debt. Municipal bonds generally pay interest semiannually and are subject to call features, as described in the bond prospectus. Municipal bonds have two different credit forms. General obligation bonds carry the full faith and credit of the issuing municipality. Revenue bonds are backed by the cash flow of the project being funded. Sometimes credit backing is both revenue from a project and a general obligation source. These are called "double barrel" municipal bonds.
General Obligation and Revenue Municipal Bonds
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General obligation bonds contain the full faith and credit of the issuing municipality and are usually rated by at least one of the major rating agencies: Moody's, Standard & Poor's or Fitch. Municipal issuance is used for accumulated projects passed by local and state authorities. Typical projects include water and sewer projects, state construction projects of state facilities, roads, jails and educational facilities.
Revenue bonds contain covenants requiring that debt service (the ability to pay principal and interest) be maintained by project cash flow with at least a 10 percent operating margin. Revenue bond projects are typically large infrastructure projects such as water and sewer services, public utility issues, road, turnpike and highway construction, and maintenance projects. Bonds are also issued for hospital and public housing construction. All of these bonds must be issued by an authority created by the local or state government agency and approved by the appropriate legislature.
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Characteristics of Municipal Bonds
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Municipal bonds have very low default rates. This is because most states are required to have balanced budgets each year so taxes are always sufficient to pay debt service. The other important reason is that the nature of the projects serves fundamental needs. Clean water projects, housing construction and hospital care are projects that are recession resistant. Collection of taxes, particularly when the revenue source is sales and property tax, have very high success rates.
State exemption of municipal bonds varies from state to state. It is important to remember that residents of one state cannot use another state's bonds to exempt themselves from their state's tax laws. Due to a legal technicality, only municipal bonds from Puerto Rico, Guam and the Virgin Islands are exempt from any kind of federal, state and local taxation.
Municipal bonds are a very reasonable investment for individuals seeking liquidity and safety. There are many municipal bond funds and exchange-traded funds in the marketplace if the individual does not wish to build his or her own personal portfolio of securities.
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