Investing in Tax-Free Bonds

A well balanced investment portfolio should include bond holdings in addition to stocks, mutual funds and other investments. The large variety of bonds available can make choosing the right ones a challenge. A common choice for investors who prefer tax-free investments are municipal bonds. States, cities and other public entities issue municipal bonds to raise revenue for public projects. Although investing in tax-free bonds is a popular choice for many investors, you should understand the benefits and limitations of municipal bonds to determine if they align with your financial goals.

Types of Municipal Bonds

Two types of municipal bonds exist: general obligation bonds and revenue bonds. State, city and county agencies issue general obligation bonds, which are considered the safer of the two bond types. The issuing entity can repay the principal and interests to investors with its tax revenue. In contrast, entities that issue revenue bonds make principal and interest payments to investors from the revenue earned from specific projects. Revenue bonds are typically not issued by state and local governments.

Interest Rates

Investors can expect to earn lower interest rates on municipal bonds than other types of taxable bonds with similar maturity dates and credit ratings. Most state and local agencies are considered stable, so municipals bonds are generally seen as low-risk investments. The tax-exempt and low-risk features of municipal bonds typically outweigh the low interest rates that accompany them, making them an attractive investment for many investors.

Benefits

The primary benefit of investing in tax free bonds is the ability to earn interest income without paying taxes to the IRS. You also receive state and local exemption if you purchase municipal bonds in the state in which you reside. Any capital gains realized are taxed. Investors in a high tax bracket can benefit greatly from investing in municipal bonds. According to Fidelity Investments, investors in a 25 percent tax bracket or higher who invest in municipal bonds with low stated yields usually realize more after-tax income than they receive from taxable bonds with higher yields. Another benefit is the ability to earn a stable income for as long as you hold the bond.

Limitations

Investors holding municipal bonds as long-term investments might find that the bond yield cannot keep up with the rate of inflation, which means that you will experience less buying power on your earned income in the long run. Investors in a lower tax bracket might not receive more interest income from municipal bonds than taxable bonds, even after the tax savings. Although tax-free bonds are considered conservative investment options, a risk of default by the issuing agency still exist. Some state and local agencies have defaulted on repaying their municipal bonds because of economic hardships experienced in their respective regions.