The Downsides of Municipal Bonds

Municipal bonds are a type of bond that provides tax-free income for investors. Even though this can be very desirable, there are a few potential drawbacks of investing in a municipal bond. In many cases, you might be better off to invest in a traditional bond that causes you to pay taxes on the income that you receive. By the time you take up taxes, you still might be ahead on your return. Municipalities are public entities that are trying to raise money for a specific project. They pay low amounts of interest on their bonds because they do not have a lot of excess cash and they know that investors are attracted to the fact that they do not have to pay taxes.

Difficulty in Investing

Another potential problem with municipal bonds is that they are difficult to invest in. Investing directly in this will bonds can be difficult because you have to work with a bond broker. In order to open an account with a bond broker, you will have to come up with $5000 to get started. Many people do not like to put up this much money right away. The bond broker will also take a commission for helping you find a municipal bond that you can invest in. Sometimes finding a specific municipal bond can be difficult and it might take some time to find one.

Inflation Risk

When you invest in municipal bonds, you will also have to be aware of the impact of inflation on your investment. Inflation is always increasing and you have to invest in things that beat inflation if you want to continue to grow your money. Traditionally, inflation averages about three percent per year. This means that you need to invest in a municipal bond that pays more than three percent in order to stay ahead. For example, if you invested in a municipal bond that paid four percent and inflation was three percent, you are only going to net one percent on your investment.

Credit Risk

You will also have to be aware of credit risk when you invest in this type of bond. Every municipality is going to have its own credit file and financial strength. When you choose to invest in one of these bonds, you are essentially loaning money to the municipality. You want to take sure that you choose a municipality that is going to be able to pay you back. Sometimes, municipalities go into bankruptcy and there is a chance that you may not be able to get your investment back. If this is an issue, you may want to look for municipal bonds that have bond insurance attached to them. This guarantees the payment of your bond regardless of what happens.

Our recent economic market has made municipal bonds riskier than ever before. Today, many cities, counties and states are declaring they are close to bankruptcy and are requesting money from the federal government. Be careful to do plenty of research before you invest.

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