The Triple Benefit of Municipal Bonds

Posted by Don on July 10, 2014

With the volatility of the stock market and low interest rates, many investors are looking for ways to earn a decent return on their money and also keep their principal safe. While it is common knowledge that you cannot earn a high return unless you take on a higher risk, you can still earn a decent return while playing it safe. To do so, look no further than municipal bonds.

municipal bonds

3 Benefits of Municipal Bonds

Municipal bonds offer investors 3 great things: safety, income and tax benefits. But as with any investment, municipal bonds aren’t for everyone. Read on for each one of the benefits that municipal bonds offer and then you can begin to decide if there is a fit for them in your portfolio.

Municipal Bond Safety

Overall, municipal bonds offer investors safety. This isn’t to say that you cannot lose money when you invest in municipal bonds, but the odds of losing money are not high. This is due to the fact that they historically have had a very low default rate.

Of course, you can’t base all of you investment decisions on history. There are many communities in California that are bankrupt. In Michigan, Detroit recently declared bankruptcy. This means that bankruptcy and default on municipal bonds can and does happen. Before you invest in any municipal bond, make it a point to research the municipality of the bond you will be buying.

Some investors have made the mistake of thinking that municipal bonds are risk-free, meaning there is no default risk. This is not true. The only investments that are truly risk-free are US Government and Treasury bonds.

Municipal Bond Income

The next great feature of municipal bonds is the income they generate. While the income isn’t life changing, it usually ranges around 5% and is predictable.

Most all municipal bonds pay interest semi-annually. But you should be aware that many municipal bonds get called. This means that a municipality will retire a bond before it matures. For example, a municipal bond might mature in 20 years but have a call feature after 7 years. When the seventh year passes, the bond can be called by the municipality. You will receive your principal back, but you lose out on the future income payments. But, with your principal returned to you, you are free to buy other municipal bonds.

What happens when the community who issued a municipal bond defaults?
One more note about municipal bond income, in the case of a municipal bond defaulting, you will not earn the interest payments going forward as well. The municipality will simply suspend future income payments. It is rare for you to lose your principal when a municipal bond defaults.

Municipal Bond Tax Benefits

The third benefit of municipal bonds is the tax-free treatment of the income. Municipal bonds are tax-free on the federal level, meaning you won’t pay federal income tax or investment tax on the income. But, many states also offer tax-free treatment to their own municipal bonds as well. This means that if you live in Pennsylvania and buy a Pennsylvania municipal bond, you will not pay state income tax on the income either. In fact, you won’t pay local tax on it. This makes the income “triple tax-free”.

Note that not all states offer tax-free treatment on municipal bonds and that if you invest in municipal bonds from another state (for example, if you live in New York and invest in a municipal bond from Kansas), you will most likely have to pay state income tax on the income.

For many investors, the tax treatment of municipal bonds (along with the predictable income they provide) make them a wise choice for those who are retired. But, as with any investment, look into the tax treatment of the income for your state before you go out and buy any municipal bonds.

Final Thoughts

Of course, as great as municipal bonds sound, this doesn’t mean that you should rush out and buy a bunch of them. You have to determine if they fit within your investment plan. There is no point in buying something that doesn’t help you reach your goals. For example, a younger investor might not invest in municipal bonds simply because he or she needs a higher rate of return.

However, on the flip side, this same investor may want to invest in municipal bonds because they are in a very high tax bracket and want to limit income taxes. Before you do anything, you need to weigh the advantages and disadvantages of such an investment. Only after careful consideration can you make an informed decision that is right for you and your situation.

More on Municipal Bonds and Treasuries





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