Historically, investors have looked to municipal bonds to protect against volatility, the risk from default, and to benefit from tax-friendly policies. Investing in municipal bonds can be a great way for investors to preserve their capital while also generating a flow of typically tax-free interest payment income. However, it can be a daunting task to dive into a market that can seem complicated and overwhelming. As such, we outline some of the basics behind municipal bonds and municipal bond investing.

When governments or governmental institutions need funding to finance certain projects that serve a civic purpose, they will issue municipal bonds (or munis) as a way to supplement revenue for these public projects. The different types of institutions that issue these bonds are states, towns, cities, counties, school districts, hospitals, transportation authorities, universities and colleges, housing projects, road and highway authorities, water districts, and power districts.

Municipal bonds are debt securities issued by these organizations to bondholders. In other words, the bondholders are lending the issuing institutions a loan that is expected to be paid back at face value at a certain date. The date that the debt is supposed to be paid back is the maturity date. The face value, or par value, of the bond is the amount of the bond when it is issued.

To entice investors to buy a bond, and thus lend money to these institutions, issuers pay interest on the bond. An extra benefit of this interest is that it is usually exempt from federal income taxes and sometimes local and state taxes as well. This interest is usually paid every six months until the date of maturity, when the face value of the bond is paid back to the bondholder. The annual rate of interest paid on the bond is known as the coupon.

An investor is not always buying an initial issue of a bond at its face value amount. Usually, the investor is looking in the bond market to buy a municipal bond that might not be sold at the amount it was issued. The value of the bond that is bought or sold at a given period of time is the price of the bond. Depending on the state of the economy and the bond market, the price of the bond could go for more or less than the actual amount of the bond. The price of a bond is expressed in cents on the dollar. For instance, if a $10,000 bond was selling for $9,500 then the price of bond would be 95.

The yield, or yield to maturity, is the rate of interest a bondholder will be paid when also taking into account the price paid for the bond as well as the length of time until date of maturity. When an investor is interested in purchasing municipal bonds, the yield is a more important indicator of potential returns than the coupon or interest rate.

There are primarily two types of municipal bonds: General Obligation bonds (G.O. Bonds) and Revenue bonds.

General Obligation Bonds

General Obligation bonds are types of munis for which issuers guarantee the repayment of the bond by any means necessary with full faith and credit. This usually means that the issuers will use their taxation power to raise the revenue to pay back the bond under any circumstances. If the issuer has problems paying back its issued bonds, then that institution must raise taxes to earn the revenue needed to pay back the bonds. The most common issuers of G.O. bonds are states, cities and towns, and school districts that rely on the local municipalities that belong to the school district to guarantee payment.

Revenue Bonds

Revenue bonds are a type of muni that are repaid using the revenues from the projects the bonds helped fund. Investors need to be aware that with revenue bonds there is a greater chance that an issuer could default on the bond. The institutions issuing these bonds can do whatever it takes to try to raise the revenue to pay back the bonds, but it may not always result in the revenues needed. For example, if a transportation authority were to issue a municipal bond in order to fund the building of a toll road, the revenue from the tolls might be used for repayment. If the issuer were having problems with paying back the bonds it could raise toll prices to increase revenue. However, this does not guarantee higher revenues as drivers could switch to non-toll roads. The ability to repay these revenue-based bonds differs among the various institutions that issue them, so investors need to take this into consideration if they are interested in investing in this type of bond.

There are over 80,000 issuers of municipal bonds in the United States. The cumulative municipal bond market is currently around $3.7 trillion. That means that municipalities across the country have $3.7 trillion in debt outstanding to the bondholders. The Federal Reserve has data that indicates that the total municipal debt outstanding went from $1.60 trillion in 2001 to $3.74 trillion in 2011-a 133.8% increase. There is always a lot of talk about the increase in the federal government debt over the years, but these numbers indicate that state and local governments have also followed that trend over the past decade.

It can be worrisome for investors that states and municipalities are incurring substantial debts in these tough economic times. There are concerns that soon these institutions will end up defaulting on their issued bonds. However, municipal bonds have a historically low rate of default, even in tough times. In the event that munis do end up defaulting, it is usually from bonds to fund hospitals or housing projects. If that potential risk is a primary concern, investors should simply steer clear of buying those types of municipal bonds.

New issues of munis occur when an institution initially offers the bonds to the market of buyers. It could be seen as an Initial Public Offering in the municipal bond world. This is when the bond is issued at its initial amount. There are a few new bonds issued every day, but the schedule of what is available and when is inconsistent.

After the initial issue of a municipal bond, the bond falls into the secondary bond market. The secondary market of munis is where most of the bond exchange occurs. This takes place over the counter, meaning that bonds are bought and sold through dealers, not on regulated exchanges like stocks. An investor can buy and sell bonds through various brokerages, either full service or discount, or through actual bond dealers. A bond transaction in the secondary market is when a municipal bond is bought or sold at a different price than the original amount. This secondary market also allows investors to buy bonds over a wide range of amounts, prices, coupons and yields.

According to the Federal Reserve, individual households (individual investors), mutual and money market funds, life insurance companies, property and casualty insurance companies, closed-end investment funds, commercial banks, and foreign investors are the most common holders of municipal bonds. Over the past 10 years, households, commercial banks, life insurance companies, foreign investors and mutual funds have increased their holdings of municipal bonds. In these volatile economic times, investing in these municipal bonds is seen as a safe way to maintain wealth for these various institutions.

Individuals own about $1.88 trillion of the total municipal debt. The most common type of households investing in munis are wealthy individuals in high income tax brackets. They are more likely to invest in municipal bonds because of the favorable tax-exemptions on income from these securities. These individual investors may be more concerned with a steady income rather than returns, a hallmark of the baby boomer generation.

Municipal bonds are issued by governmental organizations aimed towards funding activities that serve a civic duty and the public good. This includes states, towns, cities, counties, school districts, hospitals, transportation authorities, universities and colleges, housing projects, road and highway authorities, water districts, and power districts. It should also be noted that the United States territories, American Samoa, Puerto Rico, Guam, the Northern Mariana Islands and the U.S. Virgin Islands also issue municipal bonds.

As stated above, issuance of municipal bonds has been on the rise over the last two decades. As revenues from taxes and other operations have declined, these institutions have been more likely to issue municipal bonds as a way to fund civic activities.

Investors buy municipal bonds through a number of different outlets. Popular online brokerages such as Scottrade or E*Trade offer a large variety of bonds from which to choose. If an investor is knowledgeable about what they want to invest in, then this route can be beneficial as it will cut out the middleman and potential fees that could arise, as well as offer a large pool of potential bonds for purchase.

There are also local and online bond dealers that might specialize in a certain area of municipal bond depending on area or institution. The advantage offered by these specialized dealers is their knowledge about certain bonds and bond areas. They usually have a limited amount of bonds that they own and sell. However, because of this, these small bond dealers use online directories to search for a larger pool of bonds that an investor could use without the dealer. These online directories, like Munigo.com, are a great way of searching for the sale of bonds on the market.

Be careful when dealing with certain bond dealers as they might have an incentive to sell questionable bonds that benefit their commission rather than an investor’s portfolio. This can include bond-specific dealers as well as financial advisors from full-service brokerage firms. Many times, dealers and advisors are not schooled in all areas of municipal bonds, so it could be a disadvantage for an investor to take strict advice from anyone. Like any area of investing, investors should do their own due diligence in determining what municipal bonds are right for their given situation.

Investors must be aware that though the risks are limited, municipal bonds are not risk free. As with any investment, do the homework necessary to determine if the municipal bond path is the right one for you. Investors must take into account the default risk, the potential interest rate risk (munis are fixed-rate instruments, so if interest rates go up then bondholders are missing out on potentially higher interest returns) and call risk (if a bond issuer decides to pay back the bond amount at a given time). Also, the liquidity of these bonds might not be as easy as some investors might prefer. Depending on what type of bond an investor holds, it might not sell right away. However, if an investor is willing to put in the work, municipal bonds can be a great way to see steady tax-exempt income with minimal risk.