For people with income as a primary objective, investing in municipal bonds may be a great vehicle to help attain that goal.
Municipal bonds are issued by state and local governments to raise money for major capital projects. This includes the building of infrastructure such as bridges, roads, hospitals, schools, sewer systems, stadiums, airports, power plants and prisons, or to provide for other needs of local government. Virtually all states and local governments issue municipal bonds from time to time. The $2.7 trillion* municipal bond market consists of over 50,000 issuers across the country.
Like any borrower, local governments pay interest on municipal bonds to investors who own or hold them. Interest on municipal bonds is typically paid every six months. Interest earned from municipal bonds is exempt from federal income taxes, and, depending on the residence of the bond holder, may also be free of state and local taxes.
As a general rule, interest income is exempt from state and local taxes if the investor lives in the same state as the bond issuer.
Investors have viewed municipal bonds as safe investments because rated investment grade municipal bonds have had an average cumulative default rate of just 0.08 percent between 1970 and 2011.** The reason for this low historical rate of default is that many municipal bonds are backed by the unlimited taxing power of the local government issuing them. Such bonds are referred to as “General Obligation Bonds” (or “GO Bonds”), and are backed by the full faith, credit and taxing power (i.e. income, property, sales, and vehicle taxes, tolls, special levies, etc.) of an issuer to pay back the principal and interest owed to bondholders. General Obligation Bonds thus offer a measure of safety to bondholders because unlike corporations, local governments rarely cease to exist and dissolve altogether. As long as they exist, municipalities should be able to generate tax revenue sufficient to meet their obligations to bondholders.
Another type of municipal bond is a “Revenue Bond,” which is backed not by taxes, but by revenue (i.e., toll revenue or electric power revenue).
The safety of a bond will vary based on the revenue streams backing it, which is why we recommend working closely with a municipal bond specialist when selecting bonds for your portfolio.
For many income investors, municipal bonds have proven to be a great investment to help them achieve their income goals. As with any investment, there are risks involved, so it is highly recommended to seek out a financial advisor with a strong knowledge of municipal bonds. This professional will be able to help guide you in building a secure portfolio that provides a steady stream of income.
*Lazard Insights, December 15, 2009
**Moody’s Investor Service, “U.S. Municipal Bond Defaults and Recoveries, 1970-2011”. March 7, 2012
About the Author: Bill Walsh is the co-founder and president of Hennion & Walsh, a full-service brokerage firm based in Parsippany, specializing in municipal bonds.