Why investors cram into this often overlooked security
With proposed legislation to raise income taxes and capital gains taxes circulating in Washington, DC, municipal bonds have become an attractive option for investors seeking tax-free income and low-risk investments. for their wallets. However, it is important to note that rising interest rates and credit risks can present serious risks, especially when it comes to high yield bonds. In 2021, municipal bonds and ETFs attracted more investment than at any time in the past 25 years. But is it the right investment for you? A financial advisor can help you decide on a bond strategy for your portfolio. Here’s what you need to know before investing.
What are municipal bonds?
Municipal bonds work like any other type of bond, although they are issued by state governments, municipalities, or county governments. These organizations sell municipal bonds as a means of raising capital for expenses such as new roads, public transit, social programs and more. These are basically loans that you give to a government entity in return for interest payments.
However, one of the most important differences between municipal bonds and other types of bonds or fixed income investments is that municipal bonds grow tax-free. Holders of municipal bonds are not only exempt from federal income tax on their earnings, they are also generally exempt from all state and local taxes. There aren’t a lot of investments that can really grow tax free.
It should also be noted that municipal bonds fall into two main categories: general bonds and tax obligations. General bonds are used to cover general expenses and then reimbursed by tax revenue. Tax obligations are used to pay for specific projects, such as a toll road, and then repaid using the income from the project itself.
Why are municipal bonds popular?
As previously stated, municipal bonds are a popular investment due to the fact that you are unlikely to owe taxes on your income. Although they earn at relatively low rates compared to the stock market, for example, they are a popular option for high net worth investors looking for a way to generate additional cash flow.
Municipal bonds are very popular. In fact, municipal bond mutual funds and municipal bond exchange-traded funds (ETFs) attracted more than $ 88.5 billion in 2021 alone. what a comparable period over the past 25 years. That said, it’s not like municipal bonds are a niche investment.
Potential disadvantages of municipal bonds
As with any investment, municipal bonds carry a certain level of risk. It is easy to determine the rating of any bond, as the credit risk levels are assigned by third parties and range from AAA to D, or defaulted bonds. You should pay close attention to the credit rating of any bond before you buy it, and you should also remember that there are risks of default regardless of the rating. However, the default rate on municipal bonds is much lower than that of corporate bonds.
Purchase risk is also associated with the purchase of municipal bonds. In some cases, the bond issuer will redeem a bond before the maturity date. You will still receive the bonus, but your income stream will end prematurely in such a case. You should also be wary of market risk, as the value of your bond will fall if interest rates rise. In such a scenario, you could lose money if you decide to sell your bond before it reaches maturity.
Should you invest in municipal bonds?
As with any financial product or instrument, the decision to invest depends on you and your financial situation, goals, and other factors. However, it is worth taking a look at the overall economic environment before deciding to invest in municipal bonds or fixed income investment products.
We currently live in a low interest rate environment and there is a lot of talk about raising both income tax and capital gains tax. While low interest rates don’t make municipal bonds an attractive investment, higher taxes certainly do. In addition, some municipalities still issue high yield bonds in this environment.
However, if interest rates rise in the near future, which they certainly do, municipal bonds purchased now could lose value. It’s important to remember that you will still receive your interest payments as stated in the original bond terms, but in a higher interest rate environment, you might be more interested in other investments or higher yield bonds. In this case, your low-interest bond could be worth less if you decide to sell it.
Municipal bonds haven’t always been a popular investment, but they have recently become a great fixed income investment, especially for high net worth investors looking to avoid tax obligations while generating additional income streams. However, just because they’re popular right now doesn’t mean they’re right or they’re right. As with any investment, municipal bonds are not exempt from certain risks. Be sure to take note of a municipal bond’s credit rating and make sure it matches your portfolio and long-term investment goals before investing.
Tips for investing
There are many different asset classes to invest in, and it can be difficult to determine which ones are best for you. A financial advisor can help. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors in your area, and you can interview your correspondents free of charge to decide which one is best for you. If you’re ready to find an advisor, start now.
If you’ve decided to build your investment portfolio on your own, you need to make sure you’re ready. SmartAsset offers you a number of different online investing resources to help you figure things out. Check out our free asset allocation calculator today.
Photo credit: © iStock.com / primeimages, © iStock.com / designer491, © iStock.com / Maximusnd
The article Why Investors Crock Into This Often-overlooked Security first appeared on the SmartAsset blog.