Municipal bonds are the bonds that are issued by cities, countries, government entities below the state level, airports and ports to collect funds for developing infrastructure like roads, buildings and schools and other obligations.
Municipal bond holders do not have to pay federal income tax and start income tax on the interest received by them. However municipal bonds that are created with specific purposes are not exempted from tax.
Municipal bonds provide interest at either variable rate of interest or fixed though there is a limit above which interest cannot be paid to the bond holders. The bodies or government entities which issue Municipal Bonds get cash from the bond holders and utilize it to pay for major projects. Funds accumulated from the sale of Municipal Bonds have to be spent on the projects within three to five years after the bonds are issued. However, in some cases, funds raised from Municipal Bonds can be used for maintenance expenditure or giving funds for student loans.
Since Municipal Bonds are exempted from payment of tax, investors have no problem in getting lower interest rates, making Municipal Bonds an attractive and cheaper way of collecting funds for those issuing such bonds as they have to pay low interest rates.
Municipal Bond holders can buy bonds either from primary market i.e. buy the bonds directly when they are issued or from the secondary market i.e. buy the bonds from the other investors. Usually, many bond holders receive payment of interest half-yearly. However, in case of short term municipal bond holders will get the interest along with its principal only at the time of maturity of the bonds.
In United States, Zero Coupon Municipal Bonds are also issued which, unlike other Municipal Bonds which pay interest half-yearly, do no pay interest until the maturity period. Like other Municipal Bonds, the interest paid to the investor is exempted from the taxes.
Another risk involved in buying Municipal Bonds is that in case, the interest rate prevailing in the market is high; the investor will get low interest rate only as prescribed in the agreement. Also, if the issuer of the Municipal Bond is a small entity, the risk factor would be more as compared to the bonds issued by a large and credit-worthy entity.
If one compares taxable corporate bonds with tax-free Municipal Bonds, he may find that the tax-free Municipal Bonds will provide more yield after paying the taxes in comparison with the high-interest paying corporate bonds as the taxes paid by the corporate bond holder will decrease the net income.
Established in 1975, the board regulates all the dealers of the Municipal Bonds, municipal securities and the municipal notes in order to protect interests of bond holders and public at large. The board makes rules for the dealers, while implementation of the rules formulated by the board is done by the Securities and Exchange Commission.