What You Should Know About Investing in Municipal Bonds

Christine Parker, CFP®

Personal finance expert for women, Christine Parker, CFP® is president of Parker Financial, LLC, a registered investment advisory firm in the state of Maryland.  The information contained herein should not be viewed as Parker Financial, LLC providing investment, tax or legal advice.  Before implementing any strategy, please consult your accountant, legal counsel and financial planner.  For more information, call toll-free 866-681.PLAN (7526) or visit (1/18/11.)

The municipal bond market is experiencing volatility and sell-off, in part due to analyst warnings and investor concerns about the risk of state and city government’s defaulting on their obligations.

State bailouts have already begun with a federal government subsidy program known as Build America Bond (BAB,) which subsidizes 35 percent of the interest payment to municipal bond holders, writes bank analyst and chief executive officer Meredith Whitney at Meredith Whitney Advisory Group in a Wall Street Journal Opinion Editorial on Nov. 3.  Other analyst, including Bill Gross, fixed income fund manager at PIMCO does not share the same grim outlook.  Of the total 165.4 billion BABs issued from April, 2009 through November, 2010, 2 percent have been issued by the state Maryland, totaling $3.4 billion.

Here are five basic concepts that you need to know about investing in municipal bonds:

Issuer.  Municipal bonds are issued by states and local governments to raise funds to finance public projects, including construction of airports, hospitals, recreation and cultural facilities, schools, water infrastructure, road improvements, fire and rescue services.

Tax-exempt income.  Municipal bonds are attractive to high-income earners because they are generally exempt from federal income tax.  Income from some municipal bonds are not tax-exempt, including those that do not meet public purpose use under federal tax rules and private activity bonds that are subject to alternative minimum tax (AMT.)

Default risk. Credit rating agencies, including Standard & Poor’s, Moody’s and Fitch, will assign a bond rating on the issuer’s risk of default, which can be downgraded.  The top credit rating is AAA and a credit rating below BBB/Baa is considered non-investment grade, commonly referred to as junk bonds. 

Interest rate risk: Bonds with the longest matures are more sensitive to interest rate changes.  If interest rate rises, the market price of a bond will dro

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