If you are looking for a way to invest your money and generate a tax-free income stream, then you should consider buying municipal bonds. Also called “munis” for short, municipal bonds are debt obligations issued by a state, municipality, or a county to finance its capital expenditures, such as construction of highways, schools, hospitals, and other projects for public good.
By purchasing a municipal bond, you lend money to a state or local government entity (to sponsor certain projects), which in turn promises to pay you a specified amount of interest annually or every six months, and return the principal to you on a specific date.
There are two major benefits of buying municipal bonds. First, the interest you earn from your municipal securities is exempt from federal income tax and in some cases, state or local income tax—depending on whether you reside within the state that issued the bond. Second, your chances of losing are very slim. Though municipal bankruptcies and defaults can and do occur, they have been relatively infrequent when compared to what obtains in the corporate bond market. Here are the various types of municipal bonds.
8 Types of Municipal Bonds
1. General obligation bonds
These municipal bonds are issued by governmental entities, but are not backed by revenues from the project they are used to sponsor, such as a toll road. While some general obligation bonds are payable from general funds, others are backed by dedicated taxes on property. The former types of binds are often referred to as “backed by full faith and credit” of the governmental entity. “General obligation” in many instances means that the issuer has unlimited authority to tax residents to pay bondholders, there are instances where the governmental entity has limited or no taxing authority.
2. Revenue bonds
These are municipal bonds for which the payments of both the principal and interest are secured by revenues generated by the governmental entity (usually from the project sponsored by the bondholder) or by taxes such as sales or fuel taxes. However, in an instance where a municipality issues binds as a conduit issue, a third party is responsible for paying both interest and principal. Aside governmental entities, non-profit organizations and private sector corporations also issue revenue bonds.
3. Taxable municipal bonds
As the name implies, the income generated from this type of municipal bonds is not tax-exempt. Municipal bonds are taxable when the projects sponsored by bondholders do not provide significant benefit to the public. Bonds issued to finance projects like stadiums, renovation of government offices, and investor-led housing are few examples of taxable municipal bonds.
4. Zero-coupon bonds
Zero-coupon municipal bonds are issued at an original issue discount, with both principal and accrued interest paid only at maturity. In other words, buyers of municipal bonds will not be paid their interest annually or semi-annually; they get their total accumulated interests alongside the principal at the end of the maturity period. However, annual interest reports are usually available to update bondholders about their investment and income.
5. Market discount bonds
A market discount bonds is a municipal bond that is purchased for less than its value at the secondary market. Bonds may be sold at a discount for different reasons. These include changes in market conditions, change in the issuer’s credit rating, changes interest rates, or other events affecting the issuer.
6. Insured bonds
As the name implies, insured bonds are municipal bonds insured by policies written by commercial insurance companies. In case the issuer defaults, the insurance company will pay both principal and interest to bondholders. Before you buy an insured bond, factor in the creditworthiness of both the issuer and the insurance company. Even if the issuer defaults, you still won’t get your investment back if the insurer is also financially unstable.
7. Escrowed-to-maturity (ETM) bonds
Municipal bonds are said to be “escrowed to maturity” when the proceeds of a refunding issue are deposited for investment in an amount sufficient to pay the principal and interest on the issue being refunded. However, in some cases, the insurance company may expressly reserve the right to exercise an early call of bonds that have been escrowed to maturity. Usually ETM bonds are escrowed in government treasury accounts, where they are considered relatively safe.
8. Housing bonds
Housing bonds are special securities backed by mortgage and loan payments. These bonds can be called at any time from the repayment of principal on the underlying mortgages of the housing authority. However, they are not reflected as part of a traditional “call schedule”.
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