OK, so let's start with the basics of tax-free municipal bonds.
What are tax-free municipal bonds & How do tax-free municipal bonds come into existence?
Municipal bonds, also referred as "Munis" are issued and brought to the market by local governments & official bodies to fund their day-today operations like build or repair facilities such as schools, community centers, toll-bridges or sewerage treatment plants. Hence the bonds issued by these government bodies are referred to as Municipal bonds.
Fine with municipal bonds, but what are tax-free municipal bonds?
Generally, to attract investors in large numbers, the government offers some respite in taxation from the interest earned on these bonds. Interest from municipal bonds is exempt from federal income tax and may also be exempt from state and local taxes. Hence, the municipal bonds become tax-free municipal bonds.
For e.g., if you buy a municipal bond which offers an interest or "coupon" rate of 6% annually, and you invest 10,000 $ in this bond, then each year you will get $600 as interest on this investment in municipal bonds.
Now if the municipal bond is tax-free, then the interest that you earn, i.e. $600 becomes a tax free income for you. Hence the name Tax-free municipal bonds.
Can I trade on tax-free municipal bonds?
Theoretically, yes you can trade on tax-free municipal bonds. The trading activities are based upon the interest rate fluctuations.
You can also buy or sell existing bonds before they mature. Say if the interest rates have gone up since the bond was issued, the bond will be worth less than face value. If interest rates have fallen, the bond will be worth more.
You can figure it out. Say interest rates have gone up from 6% to 8% since you bought the $10,000 bond. Anybody who buys the bond from you will still get $600 a year in interest. But who'd want your bond at $10,000 if the new bonds are paying 8%, or $800? That's what leads to trading activities, and hence one can profit (or book losses) when the interest rates fluctuate.
What are the benefits or advantages of investing in tax-free municipal bonds?
Tax benefit is one of the major advantages or benefits of tax-free municipal bonds.
Secondly, if you are an active bond trader, you can also benefit from the interest rate fluctuations, provided you know how to trade on bonds, taking the maximum profits.
Thirdly, the tax-free municipal bonds are issued by government bodies, hence they are considered to be risk free.
Fourthly, you know exactly how much money will you receive and when. So there is no uncertainty. Though price of bonds may fluctuate if the interest rate changes.
What are the risks associated with tax-free municipal bonds?
The pricing risk or interest rate risk. So if the interest rates fluctuate a lot and you are looking for trading on these tax-free municipal bonds, then you may have to book a loss.
Also, one needs to be careful about the tax benefit that he is getting. If an investor is in 30% tax bracket and buys a taxable bond paying 5% interest or coupon, then he would effectively get only 3.5% after tax deduction. Hence, this can be a better investment than a tax-free municipal bond which offers only 3.45% tax free interest rate.
Another risk is the credit risk, which is due to the rating of the bond issuing organization going down. This will send wrong signals in the market and the price of the bond might go down. However, people holding the bond to maturity may not worry as they will still get the same benefits.
What is the best way to invest in tax-free municipal bonds?
Owing to the credit risk, the best is to diversify your bond portfolio and hence invest in atleast 4 to 5 different tax-free municipal bonds. However, that may be costly as tax-free municipal bonds usually cost atleast $5000 each.
So other alternative is to invest in Money Market Mutual Funds or Bond Funds, which are like mutual funds which pool in the customer's money and offer units for cheap.
One disadvantage is that a bond fund never matures, which increases interest rate risk.
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