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.
Backed by taxes or backed by revenue
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.
Tax-backed – When a municipality uses taxes to pay back the debt, the bond is called a "general obligation bond." This just means it's backed by the taxing power of the issuing city, county or state. For example, a bond that is being issued to build a new high school would probably be a general obligation bond because the town where that school is located is "obligated" to back the loan. The residents' property taxes will make up the funds that are used to pay the interest and principal. You may be familiar with bond issues on your local election ballots. Many municipalities let voters decide yes or no on bond issues because ultimately, the bond issue will raise the citizens' taxes.
Revenue-backed – The other type of bond is called a "revenue bond." A bond that is issued to improve a local water system would be one example of this kind of bond. The citizens' water bills would be used to operate and maintain the water system and that revenue would then go toward the bond's interest and principal payments.
Where are interest rates going?
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.
How we can help
For more information on municipal bonds, please contact your local financial advisor.
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.