Municipal bond interest payments typically are exempt from federal income taxes and possibly state and local income taxes — although some “munis” are subject to the alternative minimum tax. Since not all municipal bonds are the same, you’ll want to know the differences — especially in terms of risk.
Municipal bonds face two types of risk: interest rate risk and default risk. Interest rate risk becomes clear when market interest rates rise, causing the value of your existing municipal bonds to fall. No one will pay full price for your bonds when newly issued bonds carry a higher rate — so if you plan on selling bonds before they mature, you risk losing principal. You can ignore this type of risk simply by holding your bonds until maturity, at which point you will receive the face value back, provided the issuer doesn’t default.
The second type of risk is default risk. Historically, municipal bond default rates have been lower than corporate bonds. But different types of municipal bonds carry different levels of default risk. Here’s a quick look at two categories of municipals’ risk characteristics:
• General obligation bonds. General obligation bonds generally finance projects of a municipality. A general obligation bond issuer is required to do everything in its power, including raising new taxes, to ensure that interest payments are paid on time and in full. This requirement helps support the creditworthiness of general obligation bonds.
• Revenue bonds. Revenue bonds, which finance schools, hospitals, utilities, airports, affordable housing and other public works, are paid by dedicated streams of revenue. For example, revenues generated by the sewer system pay the interest on a sewer system revenue bond. Because revenue bonds have more restricted revenue streams than general obligation bonds, they are generally viewed to be riskier. To compensate for the added risk, revenue bonds usually pay a higher rate of interest than general obligation bonds.
Consider the type of revenue bond involved. Some sectors, such as housing and health care, may be more volatile, as are some industrial revenue bonds.
When evaluating the risk potential of municipal bonds, you don’t have to rely on guesswork. The major bond rating agencies — Standard & Poor’s, Moody’s and Fitch — review municipal bonds to determine their creditworthiness. There are no guarantees, but by sticking with the bonds that are “investment grade,” you can help reduce the risk of owning a bond that goes into default.
Municipal bonds can be valuable to your portfolio. Besides providing income that’s free of federal taxes, these bonds offer a chance to help support projects in your community. Different “munis” have different risk factors — so make sure you know what type of bond you’re purchasing.
This article was written by Edward Jones for use by your local Edward Jones Financial Advisor.
Information from Edward Jones, provided by Jim Talley, financial advisor at Edward Jones, 2703 Beaver Ave., 279-4179.