Performance

• Government entities, such as cities, counties, and states, finance themselves by issuing municipal bonds to investors. In exchange, investors become creditors that receive interest payments until their bond principal is repaid. In general, interest rates shift according to risk--investors expect higher payments from riskier projects and municipalities. Municipal treasury budgets factor importantly into the interest rate equation. Unlike the federal government, municipal governments cannot run deficits, or create money through the printing press. Municipalities with weak economies and poor tax receipts typically pay higher interest rates as compensation for elevated default risks. Some investors covet municipal bonds for their favorable tax treatment. Interest from state municipal bonds is not taxable at the federal or state level.
  
  

Features

• Municipal bonds are categorized into either revenue, or general obligation bonds. Revenue bonds are backed by specific projects, such as airports or toll roads. For example, the Pennsylvania Department of Transportation may issue revenue bonds to pay for road construction on the Pennsylvania Turnpike. Tolls collected on the Pennsylvania Turnpike would then provide for the interest and principal repayments on these revenue bonds. General obligation bonds, however, are only backed by the good faith of municipal treasuries to make payments. General obligation bonds typically pay more interest, but carry higher risks than revenue bonds. You may research ratings from credit rating agencies, such as Standard and Poor's, to evaluate a municipality's ability to honor its credit promises.
  
  

Considerations

• Most investors do not have the time and resources to build a diversified portfolio of individual municipal bonds. Consider buying mutual funds that target municipal bonds for your specific state. Municipal bond funds offer diversification and professional money management, alongside favorable tax treatment. You may contact fund companies directly for prospectuses that outline key bond holdings and relevant fees.
  
  

Strategy

• Municipal bonds generally make lower interest payments than competing corporate bonds. Corporate bond interest is taxed at your ordinary income tax bracket by federal and state authorities. Because of their lower interest payments, municipal bonds are best suited for savers that carry incomes above $100,000. Municipal bonds are also ideal for residents of high income tax states, such as New York, California, Oregon and Hawaii.
  
  

Risks

• Municipal bonds are exposed to inflation and default risks. Inflation increases the costs of goods, and erodes the purchasing power of interest payments over time. Meanwhile, budget crises cause municipal bond values to lose significant value. Budget crises mean that cities, counties, and states are in danger of missing bond interest and principal payments.