Market Beat: Tax-free municipal bonds carry risk
Benjamin Franklin once said: “In this world nothing can be said to be certain, except death and taxes.” One effective way that income investors can manage their tax bill is by investing in tax-free municipal bonds.
Municipal bonds are not always completely tax free. They are free from federal income tax, but will be subject to state income tax unless you’re a resident of the issuing state. If you’re a California resident and you purchase municipal bonds issued in the state of California, the income will be free from both state and federal income tax.
Residents of income, tax-free states like Nevada can purchase municipal bonds from all 50 states. Some municipal bonds are also subject to the alternative minimum tax (AMT). You need to check on the details of the bond to determine if it’s subject to the AMT.
Municipal bonds are rated second in safety of principal only to bonds issued by the United States government, which are the safest bonds of all as they are backed by the full faith and credit of the U.S. government.
Basically, there are two types of municipal bonds, general obligation bonds and revenue bonds. General obligation or GO bonds are backed by the full faith and credit of the issuer, which means that they are backed by taxes. That can include income taxes, property taxes and sales tax. GO’s can be issued by the state or cities, counties and school districts within the state.
Revenue bonds are backed by the income from a specific enterprise, like a toll road, airport, or sports stadium. Some municipal bonds are further backed by insurance.
Municipal bonds are rated by the major credit rating agencies just like corporate bonds, so it’s simple to determine their current credit rating and whether they are on review for a downgrade. Some states are in much better fiscal shape than others.
While municipal bonds are typically quite safe from default risk, it’s important for investors to understand that default risk is not the only type of risk they face. Municipal bonds are also subject to interest rate risk.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.