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Municipal bonds are bonds issued by any
municipal organization including cities, counties, states, and school
districts. The purpose of these bonds is for general expenditures or to fund
specific projects such as highways, new schools, or an athletic stadium.
These bonds offer the municipality the opportunity to raise funds without
directly raising taxes. Of course, the funds needed to repay the bonds will
often come from a tax increase. The main appeal of municipal bonds is that
the interest payments are usually exempt from federal taxes. Many municipal
bonds are also exempt from state and local taxes in the area they are
issued. However, capital gains that occur when the bond is sold or at the
time of maturity (if the bond was bought at a discount) are not exempt from
any taxes.
Generally, municipal bonds are considered safer than corporate bonds because
a local government is far less likely to go bankrupt than a
corporation-however, it has happened in the past, so be aware of the
possibility. Because of this safety and the tax benefits, municipal bonds
generally have a lower yield than corporate bonds. In order to evaluate the
merits of a tax-free bond, you will need to calculate the tax-equivalent
yield on the bond. This is the amount of interest a tax-free bond would have
to provide to create the same return as a taxable bond. Of course, this
calculation will depend on the tax bracket of the individual, but it is an
effective way to compare the merits of taxable and tax-free bonds. Investors
should also be aware that some municipal bonds are subject to the
Alternative Minimum Tax. The bond type which is most often subject to the
AMT is one which involves a private and public partnership for something
like a sports stadium.
Some municipal bonds can also be insured by outside agencies. These
companies will promise to pay the interest and principal if the issuer
defaults. Interestingly, both issuers and bondholders can carry this
insurance, though a bondholder would need to have a large stake to get the
coverage. Another concern about municipal bonds is the secondary market. In
many cases the secondary market is very small, meaning it may be very
difficult to sell your bond if you no longer wish to hold it. For more
details about the risks that face all bonds, including municipal bonds,
visit the front page of the Bonds section .
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