If you hold it until it matures in a decade, you'll collect 20 interest payments over the life of that bond, which means that even though you're getting the same principal investment back upon maturity, you'll have profited by virtue of that interest.
Here's What Happens When a Bond Is Called
The second way to make money from municipal bonds is to sell them at a price that's higher than what you paid for them initially. Municipal bonds come in two varieties: general obligation bonds and revenue bonds. General obligation bonds are used to finance public projects that aren't linked to a particular revenue stream. Revenue bonds, by contrast, are used to finance public projects with the potential to make money. There are advantages and drawbacks to investing in each type of municipal bond. General obligation bonds are used to fund public projects that don't make money but better the communities they serve.
A city might issue general obligation bonds to build a park or improve a school system, for example. These projects won't be money-makers, but they'll improve the lives of the people who live in that city. General obligation bonds are backed by the full faith and credit of the issuer. This means that if a city issues municipal bonds, it must do everything in its power to meet its obligations to bondholders.
As such, a city might, in theory, have to raise local taxes in order to cover interest payments on its outstanding bonds. Because of this, general obligation bonds are generally considered a safer investment than revenue bonds, and historically, they've been less likely to default , i. That said, before buying general obligation bonds, you should research the issuing municipality's credit rating to ensure that it's reasonably strong. We'll talk more about that in a bit.
Revenue bonds are issued by municipalities to finance projects that have the potential to make money. Whereas general obligation bonds are backed by the full faith and credit of the issuer, revenue bonds are backed by the income streams they're tied to. A city might, for example, issue revenue bonds to fund the construction of a high-speed toll road.
The money collected in tolls could then be used to generate revenue, thereby enabling the city to repay its bondholders. From an investor perspective, revenue bonds are somewhat easy to vet, since they're tied to a specific money-making venture. That said, revenue bonds have higher default rates than general obligation bonds, and it's still important to research the issuer's credit rating before moving forward.
Unlike stocks, which trade on public exchanges , municipal bonds don't trade on a centralized exchange. Rather, they trade in a manner known as over the counter , which means transactions are conducted directly between two private parties. Generally, if you want to purchase individual municipal bonds, you'll need to find a broker who can locate the bonds you want and sell them to you.
But because municipal bonds aren't regulated the same way stocks are, you might find that you're charged a steep markup, which means your broker sells you bonds at a price much higher than what he or she paid, in addition to whatever commission or fee that broker collects. That said, brokers who buy and sell municipal bonds are required to register with the Municipal Securities Rulemaking Board MSRB , which governs the muni bond market.
And as such, they're required to disclose certain pricing information so that you, as an investor, can understand what sort of markup you're looking at.
Positivity rooted in Practicality
An additional challenge in buying individual municipal bonds is that there's often a minimum investment required just to get in on the action. Another way to invest in municipal bonds is to buy shares of a mutual fund that focuses on municipal bond investing. When you go this route, you're basically buying a share in many different muni bonds, as opposed to individual bonds. The benefit is that you get instant diversification in your municipal bond portfolio, which can help you avoid losses.
But if that city's bonds represent a small fraction of your total muni bond holdings, you won't take nearly as hard a hit.
The downside, however, is that you're subject to potentially high mutual fund fees. If you don't want to buy shares of a municipal bond mutual fund, you can instead buy shares of a municipal bond ETF, or exchange-traded fund. A muni bond ETF, much like its mutual fund counterpart, is a collection of muni bonds that you can invest in all at once. However, ETFs generally have lower operating expenses and greater tax efficiency than mutual funds, which means they often charge substantially lower fees.
Perhaps the most compelling reason to buy municipal bonds is the ability to collect tax-free interest. As stated above, municipal bond interest is always tax-exempt at the federal level, and in some cases, it's exempt from state and local taxes as well. Furthermore, while the tax benefits of municipal bonds make them a good choice for a traditional brokerage account, you probably don't want too many munis in your k or IRA.
The reason? These accounts already offer tax-deferred growth , or tax-free growth in the case of a Roth-style account.
Understanding the Risks and Rewards of Callable Bonds
Therefore you're essentially "wasting" the benefit of tax-free interest by keeping muni bonds in an already tax-advantaged retirement account. Another benefit of buying municipal bonds is that their historic default rate is extremely low, making them a relatively secure investment.
Between and , there were only 99 defaults on record among the many thousands of munis issued -- and only nine general obligation bond defaults. Further, not a single municipal bond with the highest possible credit rating experienced a default over those four-and-a-half decades.
For context, based on historical data, municipal bonds are 50 to times less likely to default than corporate bonds that carry the same credit ratings. Another advantage to buying municipal bonds is that in doing so, you get the chance to improve a community either your own or somebody else's.
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When you invest in corporate bonds, you give a major company a chance to make more money. Additionally, the price to call bond is usually a bit more than the face value of the bond — we use the price to call for this formula instead of the par value in YTM. The formula for the approximate yield to call on a bond is:. Why the disparity?
Internal to the tool, we calculate the return an investor would see then look at the present value of those cash flows. The summation looks like this:. The calculator internally uses the secant method to converge upon a solution, and uses an adaptation of a method from Github user ndongo. The discussion of the formula itself is a bit heavy, but start with our references in the Yield to Maturity Calculator to read more. Which… is what this site is, I suppose. At the time, she told this column the year Treasury yield was near its peak and that U.
The year Treasury hit its peak yield of 3. Jones made a great call. Her answer: more of the same, or even lower rates in the months ahead.
Rates on the year Treasury likely will not return to their July all-time low of 1. Moreover, she says, the federal funds rate has probably hit its cyclical peak, and the yield curve is inverted , which means the likelihood of a U. She also had some advice on what income investors should do in this low-yield world.
To Jones, demographics and the weaker global economy are two critical factors that will keep rates low. So, an aging population, slower economic growth, structurally low inflation, and stronger demand for bonds are a recipe for lower rates for some time to come. This scenario is playing out in Japan, whose population is in rapid decline , and Europe, which, Jones explained, has not completely recovered from the Great Recession.