Municipal bonds (commonly known as "munis" or "muni bonds") are debt obligations issued by cities, counties, states, and other government entities to raise funds that are used to build schools, roadways, hospitals, sewer systems, and other infrastructure projects that benefit the public. A muni bond is essentially an IOU from the issuer with a specified repayment date and a predetermined schedule of interest payments. Like other debt instruments, munis are bought and sold between dealers and investors and you have multiple investment options to choose from.

Types of muni bonds

There are two main types of munis: general obligation (GO) bonds and revenue bonds.

GO bonds are approved by the voters within a municipality. Principal and interest are secured by the full faith and credit of the issuing authority and supported by the ability of the issuer to levy taxes. For this reason, they're considered less risky than revenue bonds, but they usually pay a lower interest rate.

Revenue bonds are issued to finance public works projects such as bridges, sewer systems, or tunnels. Revenue bonds aren't supported by the taxing power of the municipality issuing the bond. Because they're generally dependent solely on the successful operation of the project they fund, revenue bonds are considered riskier, and typically pay a higher interest rate, than GO bonds.

Are munis right for you?

Most muni bonds are tax exempt--the interest payments you receive aren't subject to federal income tax. Applicable state taxes still apply. However, if you're a resident of the state where the muni is issued, the interest may also be free from state and local income taxes. In additional the Alternative Minimum Tax may also apply. The tax- exempt status of munis allows the issuers to effectively borrow funds at a much lower interest rate than would otherwise be possible.

Although the stated interest rate on a muni bond is generally lower than the rate offered on a taxable bond of similar credit and duration, once the effect of income taxes is considered, a tax-free muni bond investment may actually provide a greater after-tax yield.

The higher your tax bracket, the more attractive a tax-exempt investment becomes. The chart above compares various tax-exempt yields with their taxable yield equivalent. For example, if your marginal tax rate is 35%, a taxable investment would need to yield 9.23% to equal a tax-exempt yield of 6%.

Given their tax-exempt status, munis generally make the most sense for investors in higher marginal tax brackets (generally, over 28%). For those in lower brackets, the higher interest rate provided by a taxable bond often provides a higher after-tax yield.

Your Stage 2 Financial Professional can help you crunch the numbers and determine if investing in tax- exempt munis is right for you.

*State and local income taxes may result in even higher marginal tax rates.

Other factors to consider

Like other types of bonds, munis are subject to a variety of risks, including market risk (munis rise in value when interest rates fall, and fall in value when rates rise so that your investment may be worth more or less than the original cost); credit risk (the issuer may be unable to make interest or principal payments); and inflation risk (as consumer prices rise, the purchasing power of fixed investments is reduced). Discount bonds may be subject to capital gains tax.

Although most munis are tax exempt, there are also taxable muni bonds. Taxable munis were developed because the federal government won't subsidize the financing of projects that don't provide a significant benefit to the public at large (for example, the construction of a local sports facility). Because they don't offer the benefit of tax-free interest, these munis carry an interest rate more comparable to corporate bonds than to those of tax-exempt munis.

For more information on how municipal bonds might fit in your investment profile, please give your Stage 2 Financial Professional a call. We suggest you never make any investment decisions unless you consider your long-term goals as well as changes that might happen to your financial situation. A conversation with your Financial Professional can help in both of these areas.

With warm regards,

Stage 2 Planning Partners

Josh Patrick © 2006

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