Tax Exempt Municipal Bonds: The Fundamentals

Tax exempt municipal bonds are government-issued long-term securities that are not taxed. Although they are traditionally considered one of the safer investment options, the sub-prime mortgage crisis of 2008 undermined customer confidence in tax exempt municipal bonds and their value. It is more important than ever to understand what tax exempt municipal bonds are and what they can do to help your financial portfolio.

Understanding Municipal Bonds

Municipal bonds are issued by federal, state and city governments in order to raise money for long-term and short-term projects. This can include everything from road construction to street beautification. They don't generate as much money as many private investment options, but because they are backed by governing bodies, the municipal bonds are usually considered safer then private investments. Investors earn money by taking out municipal bonds and waiting until they collect interest.

In order to encourage investments, the governing entities that issue municipal bonds usually make profits from investing in municipal bonds tax-free. Usually, this means federal taxes, but in some cases, investors may also be exempt from state taxes.

With short-term municipal bonds, investors get back their money back (with interest) after one year. With long-term municipal bonds, the interest is deposited into the investors' accounts on an annual basis.

Which Municipal Bonds and Tax Free

Tax-free municipal bonds fall into two categories. They include:

• General obligation bonds - tax exempt municipal bonds that are issued directly by the governments. They are backed by the governments' ability to tax its citizens.

• Revenue bonds - tax exempt municipal bonds that are issued by third-party entities that are sanctioned by the government. This can include entities such as water companies, power companies and toll road operators. The bonds are backed by the revenue generated through the third party entities provide. If, for example, the revenue bonds are issued for water companies, they are backed by the value of the water bills their customers pay.

Finding Safe Tax Exempt Municipal Bonds

Municipal bonds are usually considered safe because they are backed by governments, which are less likely to collapse then private companies. But while this is true for United States federal government, this may not be the case with individual cities and states. Investors should be particularly careful when it comes to bonds issued by cities.

In order to be secure, the city needs to have a stable, diverse economic base, growing population and comparatively low per capita crime rates. Rust Belt cities that haven't successfully switched over from the industry-centric economy (such as Detroit) are more vulnerable the cities that have switched over to the new system (such as Chicago). Furthermore, the cities that depend on a single major economic engine (such as tourism) are less vulnerable than the ones that has a variety of income generators.

Another important factor to keep in mind when it comes to assessing the safety of the tax exempt municipal bonds is that is responsible for servicing the interest payments on the bond. Investors should also look at the municipality's past record with handling tax-exempt bonds. If it has a history of falling behind on payments, or defaulting, it is less likely to offer municipal bonds one can safely invest in.