The Best Municipal Bonds

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Investors in municipal debt should have a diversified portfolio.
Investors in municipal debt should have a diversified portfolio. (Image: Jupiterimages/Photos.com/Getty Images)

The best municipal bonds are those that together create a portfolio that meets the income and credit quality that an investor needs to reach her investment portfolio goals. This implies an understanding of the risks of credit quality, the after-tax yield of municipal bonds, the risks of long maturity bonds and the need for portfolio diversification.

Municipal Bond Properties

Every municipal bond contains an interest rate, or coupon rate, a maturity and a yield to maturity based on the general level of municipal rates and current municipal bond yields available for bonds with similar credit ratings. Because municipal bond prices are inversely related, bond yields rise with lower bond prices. For investors, that means that better rated bonds will result in lower yields. Rating services generally divide municipal bonds between stronger investment grade and riskier speculative grade offerings. Investors are advised to study any rating assigned to a bond by credit reporting agencies. Strong credits have guarantees of strong asset backing and cash flow and provide the best bonds for long-term investors.

After Tax Yield

The best bonds for an investor depend on the investor's state of residency. All municipal bonds are exempt from federal taxation. Some states allow their state issues to be exempt from state and local income taxes. No state honors another state's bond as exempt. The only exemption is in United States territories, which are exempt from all taxation. There are 14 United States territories. Not all territories issue bonds. The best bond for any investor is either of his resident state or a tax-exempt United States territory.

Choosing a Municipal Bond Maturity

Investors can usually increase yield simply by increasing maturity. Choosing the best municipal bond requires an understanding of risk in bond maturity. Bond prices fluctuate as maturity increases. This municipal bond volatility increases at an increasing rate. Yield considerations must be weighed against price risk. The best bonds to buy are not subject to call features, or the risk of early redemption, by the issuer. Bonds with call features may be redeemed during periods of low interest rates, resulting in the bondholder having to buy municipal bonds in a low interest rate environment. If non-callable bonds are not available, consider municipal bonds that trade at a discount below par, the bond's redemption value.

Diversification of a Municipal Bond Portfolio

Municipal bonds are generally of superior credit quality. Given the many different risk considerations bond investors must consider, there is one investing technique that improves investor risk-and-reward considerations: diversification. Diversification means buying as many different bonds that meet minimum maturity and credit considerations. This lowers the risk of any one bond negatively affecting your returns. Beginning investors may want to consider municipal bond funds as a means of diversification until they can purchase several different bond issues for their portfolio. The best municipal bond is one of many in a diversified portfolio.

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