Municipal bonds, along with their related exchange traded funds (ETFs), have been long used as a tax shelter for high-net worth investors, but they’re there for anyone seeking a steady stream of income.
What Are They?
Municipal bonds are issued by cities, counties or states that are in need of cash to fund development of projects, such as schools, airports, hospitals or other municipal amenities. Some states have taken extreme steps or out-of-the-ordinary tactics to balance budgets as revenues decline and bills rise, and bondholders seem to think favorably about the actions taken.
Muni bond ETFs hold a variety of municipal bonds issued by various states and localities. Top holdings may include “general obligation bonds,” or munis backed by credit and tax revenues from the project. General obligation bonds are considered the safest among the types of municipal bonds available since the bond is covered by the taxing power of the issuing party. Revenue bonds, issued to fund infrastructure projects, are supported by the revenue generated from the project.
Muni Bond Benefits
Low Risk. Historically, the default rate of muni bonds is minuscule. If an investor were to sell bonds before a maturity date, one may get less than what one paid for, especially given the fiscal problems in some states. Still, some states may issue a forced rollover into a new bond to pay off the old in which case the bond holder is issued another bond once the original matures, which has been known to happen.
Tax Breaks. Muni bonds are exempt from federal taxes. They can also be exempt from state and/or local taxes if you’re a resident of the state or locality in which you are buying them. The tax breaks may be an especially big lure if the Bush tax cuts are allowed to expire at the end of this year.