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Municipal Bonds: Definition, Types, Risks, and Tax Benefits

Municipal bonds, or “munis,” are borrowings issued by state and municipal governments and their agencies and authorities to fund public projects such as schools, roadways, sewer systems and public utilities. Municipal bonds are purchased by investors to gain tax-free income while also supporting local communities.

In this post, we will look at the definition of municipal bonds, different types of munis, risks, and tax benefits.

What are Municipal Bonds?

Municipal bonds are debt obligations issued by local governments such as cities, counties, and school districts to fund general public projects such as infrastructure, schools, and hospitals. The majority of municipal bond interest is exempt from federal income taxes and, in some cases, state and local taxes.

Municipal bonds provide investors with a consistent source of income in addition to tax advantages. Municipal bonds in India typically pay interest twice a year, and the issuer is required to make payments to bondholders in accordance with the terms of the bond’s indenture. Municipal bonds can come in various maturities, from short-term to long-term, allowing investors to adapt their investments to their personal needs. 

What Are The Types of Municipal Bonds in India?

Investors can select from a variety of municipal bonds, each with its own set of features and benefits. The following are the most prevalent forms of municipal bonds:

  1. General Obligation Bonds (GO Bonds): Municipal bonds are guaranteed by the government and are usually utilised to finance projects that benefit the entire community, such as schools, roads, and public buildings. GO bonds are considered one of the safest municipal bonds since the issuing municipality can raise taxes or cut spending to pay its debt obligations.
  1. Revenue Bonds: These are backed by the revenues generated by a specific project or facility, such as a toll road, airport, or water treatment plant. Revenue bonds are considered riskier than GO bonds because their repayment depends on the success of the underlying project or facility.
  1. Taxable Municipal Bonds: These bonds are issued by municipalities but are subject to federal income tax. They are typically used to finance projects that do not qualify for tax-exempt status, such as sports stadiums or convention centres.
  1. Insured Municipal Bonds: These bonds are backed by an insurance policy issued by a third-party insurer, which guarantees the timely payment of principal and interest even if the issuer defaults. Insured municipal bonds are considered to be less risky than non-insured bonds.
  1. Zero-Coupon Municipal Bonds: These bonds are sold at a discount to their face value and do not pay interest during the bond’s life. Such bonds may be more attractive to investors seeking a predictable income stream or looking to lock in a specific rate of return.

What Are The Risks Involved in Municipal Bonds?

While municipal bonds are generally considered to be a safe investment, there are some risks that investors should be aware of. Here are some of the significant risks associated with municipal bond investing:

  1. Credit Risk: Municipal bonds are only as good as the issuer’s creditworthiness. Investors may not receive principal or interest payments if the issuer, such as a local government or municipality, faces financial difficulties or defaults on its debt commitments.
  1. Interest Rate Risk: Municipal bonds are sensitive to changes in interest rates. If interest rates rise, the value of existing municipal bonds may decrease, resulting in capital losses for investors who sell their bonds before maturity.
  1. Call Risk: Municipal bonds may be callable, meaning the issuer can redeem them before their maturity date. This can benefit the issuer if interest rates have fallen since the bonds were issued. Still, it can be disadvantageous for investors counting on a predictable income stream from the bonds.
  1. Market Risk: The value of municipal bonds can be influenced by broader market factors, such as changes in investor sentiment, economic conditions, or geopolitical events. These market factors can cause the value of municipal bonds to fluctuate, which can result in capital losses for investors.
  1. Liquidity Risk: Municipal bonds may be less liquid than other types of investments, making it difficult for investors to sell their bonds at a fair price. This is especially true for smaller municipal bonds issued by less well-known issuers.
  1. Inflation Risk: Inflation can erode the purchasing power of the interest payments and principal of municipal bonds. If inflation rises faster than the interest rate on the bonds, investors may experience a net loss in real terms.

What Are The Tax Benefits of Municipal Bonds?

Municipal bonds also provide many tax advantages to investors. Here are some of the tax advantages of municipal bonds:

  1. Federal Income Tax Exemption: Most municipal bond interest is tax-free under federal law. This means that the investor’s taxable income does not include the interest income for federal tax purposes. As a result, investors in higher tax brackets can earn a higher after-tax yield with municipal bonds than with taxable investments.
  1. State and Local Tax Exemption: Some municipal bonds may also be exempt from state and local taxes. This depends on the state of residence of the investor and the state in which the bonds were issued. For example, if an investor resides in a state that imposes state income tax, they may be able to avoid state income tax on the interest earned from municipal bonds issued in their state. 
  1. Alternative Minimum Tax (AMT) Exemption: Municipal bonds are also exempt from the Alternative Minimum Tax (AMT), a separate tax system designed to ensure that high-income taxpayers pay a minimum amount of tax. This exemption means that investors can avoid paying the AMT on the interest earned from municipal bonds.

The Bottom Line-
Municipal bonds are a popular investment option for individuals looking for tax-free income and a means to give back to their communities. Municipal Bonds can be a significant addition to an investment portfolio because of their tax advantages, stable income, and relative safety. If you decide to invest in municipal bonds, you should be aware of the risks involved.