Advantages and Disadvaantages of Municipal Bonds

Topics: Bond, Income tax in the United States, Tax Pages: 3 (974 words) Published: March 18, 2013
Advantages and Disadvantages of Municipal Bonds
The greatest advantage of municipal bonds can be summed up in two words: tax free. The interest rates on municipal bonds may seem low compared to similar long-term securities like Treasury bills and CDs, but tax advantages may level the playing field. Let's look at some examples. If you're in the 25 percent bracket for 2008 federal income taxes, you'd have to find a taxable security with an interest rate of 4 percent to equal the yield of a tax-free municipal bond with an interest rate of 3 percent [source: David Lerner]. In other words, if you have $5,000 to invest in a bond, you'd earn the same with a 3-percent tax-free bond as a 4-percent taxable bond. The difference between taxable and tax-free bonds becomes even more exaggerated as you climb to higher income tax brackets. If you find yourself in the 35 percent federal income tax bracket, you'd have to find a 4.62 percent taxable interest rate to yield the same amount as a humble 3 percent municipal bond [source: David Lerner]. Some taxpayers also have to pay state and local income taxes, depending on where they reside. In this case, a triple tax-free municipal bond -- exempt from federal, state and local taxes -- is highly attractive. The second major advantage of municipal bonds is that they're incredibly safe. Between 1970 and 2000, the 10-year cumulative default rate for municipal bonds was 0.04 percent [source: Fahim]. In other words, during those 30 years, less than half of one percent of municipal bonds failed to pay back the promised interest and principle. Compare that to corporate bonds -- bonds issued by private companies and investment firms to finance business operations -- which carried a default rate of 9.83 percent over that same period [source: Fahim]. Insured municipal bonds are practically risk-free, since the insurance company will pay up even if the bond issuer defaults. You can find a tax-free bond that fits your investment strategy. Put...
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