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Tax Free Municipal Bonds

What are Tax Free Municipal Bonds

If your primary investing objective is to preserve capital while generating a tax-free income stream, municipal bonds are worth considering. Municipal bonds (munis) are debt obligations issued by government entities. When you buy a municipal bond, you loan money to the issuer in exchange for a set number of interest payments over a predetermined period. At the end of that period, the bond reaches its maturity date, and the total amount of your original investment is returned to you.

Types of Municipal Bonds

Municipal bonds come in the following two varieties:

  • General Obligation Bonds (GOs)
  • Revenue Bonds (Revs)

A General Obligation Bond s a loan to a city, state, or local municipality secured by the issuer's full faith, credit, and taxing power. Revenue bonds are issued to fund specific infrastructure projects, such as a water and sewer system, and are secured by the income generated by those projects. Both types of bonds are tax-exempt and particularly attractive to risk-averse investors due to the high likelihood that the issuers will repay their debts.

Municipal Bond Ratings

Although buying municipal bonds is low risk, they are not entirely without risk. If the issuer cannot meet its financial obligations, it may fail to make scheduled interest payments or be unable to repay the principal upon maturity. To assist in the evaluation of an issuer's creditworthiness, rating agencies (such as Moody's Investors Service and Standard & Poor's) analyze a bond issuer's ability to meet its debt obligations and issue ratings from 'Aaa' or 'AAA' for the most creditworthy issuers to 'Ca', 'C', 'D', 'DDD', 'DD', or 'D' for those in default.

Call Risk

Many bonds allow the issuer to repay all or a portion of the bond prior to the maturity date. The investor's capital is returned, sometimes with a premium added, in exchange for the early debt retirement. While you get your entire initial investment if the bond is called, your income stream ends earlier than expected.