A municipal bond is a form of investment, which is issued by the local government. It is basically a loan to the local government wherein the payment will be made upon the maturity date of the bond. Furthermore, a series of payments for the interest will also be scheduled on a predetermined period.
Many individuals want to invest in a municipal bond simply because its income is tax free, as well as the capital investment is being preserved while it earns.
There are two types of municipal bonds; the taxable and the tax-exempt. For individuals, the tax exempt is the more popular one since as the name implies, there is no taxes to be paid. Municipal bonds may be in the form of revenue bonds and general obligation bonds.
General obligation bonds are issued by entities of the government to raise money to cover expenses. These bonds are paid by the taxing power of the government entities. Revenue bonds on the other hand are those issued by government entities for infrastructural projects. Payments for this type of bond will come from the income that the project will earn. So, exactly what are the risk factors of investing in municipal bonds?
Credit Risk
No investment is risk free. Municipal bond risks includes credit risk. This is the inability of the entity which issued the bonds to pay back what it has owed. When the issuing government entity failed to raise its financial obligations, most likely, owners of municipal bonds may not be given scheduled interest payments and worse, may not even be paid on their principal investments.
For support to individuals who invest in municipal bonds, evaluations are periodically made by rating agencies. This will serve as guide to investing individuals which government entities could have a high percentage of being able to make payments.
In addition to this guide, municipal bonds are supported by insurance policies to ensure that their investment will be paid on their maturity date regardless if the government entity did well or not. Insured municipal bonds are better options even if the interest rates are lower because there of the guarantee that your investment will be returned upon maturity even if the government entity which issued those bonds did not do well. These insured municipal bonds can be considered to be among the best municipal bonds since there is no losses in your capital, as well as interests are also paid out.
Interest Rate Risk
Another municipal bond risk is the interest rate risk. Though the interest rates for municipal bonds are fixed until their maturity date, when interest rates in the market fluctuate, the yield of the municipal bonds is also affected. If there is an increase in the interest rates, the yield of your municipal bond will be lower than the yield of those newly issued municipal bonds.
Since municipal bonds offer tax free income, municipal bond rates are relatively lower than those of taxable bonds. Taxable bonds offer high yield municipal bonds.
Call Risk
This is when the government entity pays the owner of the municipal bond whether in full or partial before the maturity date. The investment capital is returned with a certain amount added to compensate the early settlement of the retirement.
Market Risk
Market conditions also affect the price of some municipal bonds. The principle here is the same as with interest rate risk. However, if you purchased a municipal bond and kept it until its maturity date, it will not be affected by the market risk. But if you sell your investment before its maturity rate, then market conditions will affect the income of your investment.
The best time to buy municipal bonds is when there is an appealing offer for interest rates or yields.