In Part One of this series the focus was on bonds, and the bank insurance or government backing behind them that offers safety to investors. Left out of that post were state and local bonds, commonly called municipal (or muni) bonds. Like the bank CDs and federal government debt we discussed yesterday, muni bonds are a promise - in this case by a state or local government to pay you a rate of interest plus your principal back. The question with any bond is: who stands behind that promise? The backing of a muni bond can be as broad as the entire tax base of a state or as narrow as the revenues of a parking garage. Muni bonds carry credit ratings, and despite the bad press for the ratings agencies due to the mortgage crisis, I strongly urge bond buyers not to ignore that rating, since the strength of a bond's backing can and does vary widely. That said, careful investors find most muni bonds to be a safe and stable form of investment, whether one buys the bonds directly or through a mutual fund.
There is an additional form of safety here not available to investors in CDs or US Treasury bonds: the safety from federal income tax. Just because you get your principal back when you invest in a bond doesn't end the story. For many people a big chunk of their investment earnings must go for federal and state income tax - and starting in 2013 some investors will have to pay an additional 3.8% tax on interest and dividends. But muni bonds not only let you escape the new 3.8% tax: in most states the interest earned is free from both federal and state income tax. With some taxpayers seeing their tax bill heading toward 40% a muni bond offers an important element of safety: tax freedom.
Next we'll review how bond mutual funds differ from bonds themselves.
(This article contains the current opinions of the author but not necessarily those of Brighton Securities Corp. The author's opinions are subject to change without notice. This blog post is for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities).