Before I address investing in municipal bonds, which are issued by state and local governments in the U. S, I would suggest that the reader refer to the prior Investment Boot Camp post, “IBC–Bond Basics”, which is linked as follows: https://thetruthoncommonsense.com/2015/08/13/ibc-bond-basics/. “Munis” are commonly thought of as being “tax-free”; however, that is not completely the true.
The coupon or interest paid on municipal bonds is exempt from the Federal Income Tax. Also, interest paid on bonds issued within the investor’s state of residence, might be exempt from that particular state’s income tax, if there is one; but, even that’s not always the case.
Capital gains and losses, however, are indeed subject to federal tax treatment. For instance, bonds purchased for less (a “discount”) than the “face amount” (maturity or “par” value) would create a capital gain if they are redeemed at the face amount, or if they are sold at more than the purchase price. Conversely, bonds that are redeemed or sold for less than the purchase price would result in a capital loss. Consult your tax advisor or http://www.irs.gov to determine whether gains or losses would be short or long-term treatment.
There are two basic types of municipal bonds: general obligation and revenue bonds. “GO’s” are repayable from the full faith and taxing ability of the particular issuer. That means that any and all resources of the particular state or local government could be called upon to pay interest and principal on the bonds. “Revs”, on the other hand, are generally issued by a specific “authority”, of the state, county or city, and only the revenue available to that particular authority would be used to pay the interest and principal.
Although GO’s are commonly considered to be stronger than Revs, that is not necessarily the case. For either type of bond, I would generally recommend investing in one that is issued by states, or by the government or an authority, of a large metropolitan area. Small towns and rural counties may not have a diverse enough economy, and their employment opportunities might be highly limited. Alternatively, a revenue bond that finances projects, let’s say, for a large regional airport, seaport or utility could, in fact, be a safer investment than some GO’s.
Hospitals and sports authorities can represent particular credit (or repayment) risk. Other than well-known hospitals (i.e. Johns Hopkins or the Mayo Clinic), many county hospitals have a low bed occupancy rate and a large percentage of poor, uninsured patients visiting the Emergency Room. Likewise, sports teams that do not have loyal fan bases–regardless of the Win-Loss record–might have difficulty repaying their bonds. Either way, limited revenue generally results in repayment difficulties.
Before you invest in municipal bonds–or any investments–know exactly what you are investing in. Diversify your risk by investing in: a number of bonds; in different states, that finance different types of projects. And generally, it is good to spread (or “ladder”) the maturities of the bonds out over a period of years. Personally, I wouldn’t place too much trust in bond insurance; because, as we have seen in the past, bond insurers might not be as solid as first thought. Focus on what is financed, rather than who the insurer is!