What Are Tax-Exempt Municipal Bonds?
As explained in an article by financestrategists, tax-exempt municipal bonds are debt securities issued by governmental entities, such as states, cities, and counties, to finance public projects without having to raise taxes and the interest income earned on these bonds is exempt from federal income taxes and, in some cases, state and local taxes, making them attractive to investors – particularly high-income individuals.
What Are the Various Types of Tax-Exempt Municipal Bonds?
There are two main types of municipal bonds: General Obligation (GO) bonds and Revenue bonds.
- GO bonds are backed by the full faith and credit of the issuing government and are supported by its taxing power.
- Revenue bonds are backed by the revenues generated from a specific project or enterprise, such as toll roads or water systems.
What Are the Benefits of Tax-Exempt Municipal Bonds For Investors?
- Tax-Exemption on Interest Income
- The interest earned on these bonds is exempt from federal income taxes and, often, state and local taxes, making them particularly attractive to investors in higher tax brackets.
- Potential for Capital Appreciation
- They offer the potential for capital appreciation, as bond prices may rise in response to changes in market conditions or credit quality improvements.
- Diversification of Investment Portfolio
- They have a low correlation with other asset classes, such as stocks and, as such, can provide diversification benefits to an investor’s portfolio and help to reduce overall portfolio risk.
What Are the Risks Associated With Tax-Exempt Municipal Bonds?
- Credit Risk
- Credit risk is the possibility that the issuer of a municipal bond may default on its debt obligations. Factors such as economic conditions, fiscal management, and political stability can affect the creditworthiness of the issuer. That being said, the default rate for “munis” averages only 0.1% as compared to 2.2% of investment-grade corporate bonds, for example.
- Interest Rate Risk
- Interest rate risk is the potential for bond prices to decline due to rising interest i.e. when interest rates rise, bond prices fall, and vice versa. Investors who need to sell their bonds before maturity may face losses if interest rates have increased since the time of purchase.
- Reinvestment Risk
- Reinvestment risk refer to the possibility that an investor may not be able to reinvest the interest income or principal received from a bond at the same rate of return. In addition, some municipal bonds have call provisions, allowing the issuer to redeem the bonds before maturity, which can result in prepayment risk for investors. A way to mitigate reinvestment risks is to invest in bonds with different maturities, referred to as bond ladders, or reinvesting in different assets.
