How to Evaluate Municipal Bonds
"Municipal bond" is a catch-all term referring to any state or local government bond with some tax exemptions for the income the bond produces. Like other bonds, munis (as they are often called) pay a fixed annual sum, called a coupon rate, until they mature. Municipal bonds are traded on bond markets, and their prices vary. Most municipal bonds are either general obligation bonds (backed by the government and its ability to raise revenues though taxes) or revenue bonds (payments depend on income from specific projects).
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Instructions
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Determine the effective interest rate (called yield) of a municipal bond. The yield is equal to the coupon rate divided by the price you pay for the bond, not the bond's face value. The higher the yield, the more income you receive for the money you invest. If you cannot find a bond's current price in a major listing, ask your bond dealer/broker for a quote.
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Figure tax-equivalent yield. Tax-equivalent yield is what a corporate bond without tax exemptions must pay to produce the same after-tax yield as a municipal bond. Total the tax rates of taxes for which the municipal bond income is exempt, and subtract that percentage from 1. For example, if your municipal bond income will be exempt from taxes totaling 30 percent, you have 1.0 minus 0.30 equals 0.70. Next, divide the municipal bond yield by that figure. For a yield of 5.6 percent, divide by 0.70 to get 8.0 percent. So a corporate bond would have to pay 8.0 percent to produce as much after tax revenue as the municipal bond.
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Check the rating of municipal bonds. Credit risk is generally very low for munis, but it's not zero. Look up the bond rating from a service such as Moody's or Standard & Poor's. AAA bonds are those deemed to have the lowest credit risk. In addition, check to see if the bonds are insured. Some governments insure their bonds, further lowering your risk. Keep in mind that the safer the bond, the lower the yield will normally be.
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Check the terms and conditions of general obligation versus revenue bonds. Some revenue bonds don't qualify for exemption from federal taxes because of the nature of the project involved. For example, a hospital is deemed "for the pubic good" and is qualified. A sports stadium probably isn't. The bond still might be a good investment for a community, but income from the bond won't be exempted from federal tax.
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Ask your bond dealer about the bond's liquidity. Many otherwise excellent municipal bond issues are very small. Consequently, their volume of trading is low, and it they might take some time to sell. If the ability to convert the bond to cash quickly is a priority for you, this could be a problem.
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Consider the maturity of the bond if you plan to hold it until it matures. If you buy a bond at a premium (above the face value) and hold it to maturity, you'll still be paid only the face value. Another factor to consider when investing for the long term in munis is inflation risk. If inflation rates are high, bonds that don't mature for many years can lose a significant part of their purchasing power by the time they mature.
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