Basically, buying a bond is extending a loan to a "borrower." In the case of municipal bonds (also known as "muni bonds"), the borrower is a city, county, state or school district. The municipality borrows the money (usually a minimum of $5,000 and going up in increments of $5,000 from there), and the bond holder receives fixed payments from the city or state usually twice a year. Then, at the end of the loan term, the borrower pays back the principal.
How you pay taxes on the interest is one important feature of municipal bonds that makes them very different from other bonds. Municipal bonds are federal tax-free and, in some cases, are free from state and local taxes too. That means, depending on where you live, you may never owe income taxes on the payments you receive from the bond's issuer (but they may be subject to the alternative minimum tax or AMT). When you retire, your portfolio returns might be lower because you're taking less risk and your health care expenses may be higher because you're older. Getting tax-free income may make sense so you can preserve every dollar possible.
To pay back the interest and principal on a bond, the borrowing municipality can raise the funds one of two ways: either using taxes or using revenue. This informs what type of muni bond the issue will be.
At Edward Jones, instead of trying to predict exact interest rate movements, we recommend a strategy called "bond laddering" to help you combat the potential for rising rates. Laddering means staggering the maturity dates of your fixed-income investments to own an appropriate mix of short-, intermediate- and long-term bonds.
The income you receive from muni bonds you've purchased will stay the same, but the market value of the bonds will vary over time. Bond prices and interest rates move in opposite directions like a teeter-totter, so when interest rates rise, bond prices fall. The risk of this lowering of bond values is called "interest rate risk." Your financial advisor has access to Edward Jones' sizeable inventory of municipal bonds. He or she can help you build a bond ladder by finding a variety of bonds with staggered maturities. Owning short-, intermediate- and longer-term bonds can help you avoid playing guessing games with interest rates, and you'll have a more diversified portfolio – which can help lower your interest rate risk.
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For more information on municipal bonds, please contact your local financial advisor.
Before investing in bonds, you should understand the risks involved, including credit risk and market risk. Bond investments are also subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease, and the investor can lose principal value if the investment is sold prior to maturity.
You must evaluate whether a bond or CD ladder and the securities held within it are consistent with your investment objectives, risk tolerance and financial circumstances.