Municipal bonds are debt based securities issued by states and cities to finance their day to day operations and to fund entities like colleges, NGOs, nonprofit hospitals etc. The main advantage of these interest paying securities is their tax exemption status. This relieves the buyers from paying taxes on the interest income and also allows the government to borrow at competitive rates so that they can fund their large projects.
The primary advantage of ‘munis’ or short term municipal securities is for people who fall within a high federal tax bracket. Since munis offer lower yields than other taxable securities, they are only able to attract people who need to seek protection from heavy marginal federal tax payment. The tax savings should be significant enough to compensate for the lower yields. They also appeal to those investors who anticipate a rise in marginal income tax rates. In situations such as economic downturns, when yields on bonds are low, the tax-free status makes a big difference.
Municipal bonds are considered as safer investments as compared to corporate bonds. Between the periods of 1970 to 2000, the cumulative default rate for municipal bonds was 0.04 percent as compared to 9.83 percent for corporate bonds. These bonds usually pay interest twice a year, so they offer a predictable (and tax free) income stream for retirees.
Selling a municipal bond before its maturity will fetch you the current market price without any penalties. However, these bonds have a liquidity risk attached to them, i.e. investors might face the difficulty of finding a buyer when they want to sell, and they may be forced to sell at a significant discount to market value, especially if it is a bond issued in a smaller city.
The economic situations, such as the financial crisis, have a massive impact on both the issuers and investors in municipal bonds. The most recent example of this is the sub prime mortgage crisis of 2008, when municipal bond market suffered steep declines.
All investments offer a balance between risk and potential return. The municipal bond market is no exception to this rule. Even though the popularity of municipal bonds has diminished since the 1980s, they still form an important component of many investors’ portfolio, especially those who like to keep their risk levels low or those who want to avoid higher income tax brackets.