Municipal bonds are debt instruments that are issued by public entities, such as municipalities, cities, states or counties, to fund their capital expenditures. The capital expenditure of public entities includes costs associated with the construction of schools, bridges, highways and other public interest projects. Since muni. bonds offer tax exemptions, they are typically bought by investors who belong to the high income-tax bracket.

How Do Municipal Bonds Work?

Municipal bonds are issued directly to investors to meet instant cash requirements. Bond issuers must spend the cash generated through the issuance of these bonds either instantly or over a period of five years from the date of issue.

When an investor buys a municipal bond, s/he is lending money to the issuing authority. In return, the issuing authority guarantees to repay the principle amount along with a specific interest. The interest is remitted either on a periodic basis or as a lump sum (along with the principal) on bond maturity.

While investing in municipal bonds, an investor should consider the following factors:

• Buy those munis that have a high interest rate.
• Evaluate the demand for the bond prevailing in the market. The greater the demand, the higher will be the returns.
• Analyze bond ratings issued by Moody’s and Standard & Poor’s.
• Evaluate the financial health of the issuer.

The Most Popular Municipal Bonds

The four most common types of municipal bonds are:

1. General Obligation (GO) Bonds: These are the most common type and the least risky municipal bonds. They are also the ones that offer the lowest yield. GO bonds are not tied to a particular project and the issuer is obligated to pay the interest and repay the principal on time.
2. Revenue Bonds: These bonds are backed only by the prospective stream of revenues from the facility being built, such as highway tolls. They are riskier and offer higher yields than GO bonds.
3. Commercial Papers: These are debt instruments issued by governments to meet short-term cash requirements. These usually mature in less than nine months and are backed by a letter of credit from a bank. Commercial papers offer low yields.
4. Private Activity Bonds: These are used to raise funds for private ventures that have a tax-exempt status given by federal law. They are riskier and offer higher yields than GO and revenue bonds.

Benefits

Municipal bonds help in:

1. Generate consistent and relatively risk-free cash flows.
2. Receive tax deductions as these bonds are exempted from most federal, state and local taxes.

Dangers

Municipal bonds are prone to the following risks:

1. Market risk: If the market interest rate rises, newly issued bonds offer a higher yield than that offered by existing bonds. In such cases, investors will buy an old municipal bond only if it is offered at a discount. So, while selling the bond, a bond holder might receive a price that is lower than the purchase price. However, investors holding their bonds till maturity are not exposed to this risk.
2. Interest-rate risk: Municipal bonds generally have a fixed interest rate. Hence, the yield of existing municipal bonds will not improve if the market interest rate rises. This impacts the demand for existing municipal bonds.