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Municipal bonds are types of debt securities distributed by states, cities, countries and any other governmental entities to account for day-to-day requirements and to finance capital projects like building schools, highways or sewer systems. By acquiring municipal bonds you are lending money to the bond issuer in exchange for a promise of regular interest payments and the reoccurrence of the initial investment or “principal”. A municipal bond’s maturity date, the date of which the issuer of the bond repays the principal, may be years later in the future. Short-term bonds mature between one and three years, whilst long-term bonds wont mature for over a decade.
The general interest on municipal bonds is excused from federal income tax. The interest may also be excused from state and local taxes if you live in the state where the bond is issued. Bond investors tend to seek a steady stream of income payments and when compared to stock investors, they may be of more risk-averse and more focused on maintaining wealth. Once given the tax benefits, the interest rate for municipal bonds is commonly lower than on the taxable fixed-income securities, like corporate bonds.
There are two most common types of municipal bonds which are general obligation bonds and revenue bonds. General obligation bonds are issued by states, cities or countries and are not protected by any assets, but are instead backed up by the “full faith and credit” of the issuer, which has the authority to tax occupants in order to pay the bondholders. Revenue bonds are not backed up by the government’s taxing power, but by revenues from a specific project or source, like highway tolls or lease fees. For some revenue bonds they are known as “non-recourse” which means that if the revenue stream dries up then the bondholders do not have a claim on the underlying revenue source. Furthermore, municipal borrowers tend to issue bonds on behalf of the private entities, like non-profit colleges or hospitals. These “conduit” borrowers usually agree to reimburse the issuer, who then pays for the interest and principal on the bonds. In certain situations whereby the conduit borrower fails to make a sufficient payment, the issuer isn’t required to pay the bondholders.
There are several advantages to municipal bonds; one being that there it is free from federal taxes. It is particularly useful for those in a high tax bracket or seeking to create a tax exempt income stream for retirement. This tax refuge offers liquidity and tax efficiency together in one. Some other advantages are that it is free form state and local taxes, covering your investment accounts from taxes allow quicker growth for compound or income than a normal taxable amount. It also allows lower volatility than stocks and a higher level of liquidity.
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