Tax-free municipal bonds are a type of investment that many professionals encourage people to consider. You'll likely have some questions about what they are and how they work. Let's look at some of the responses a tax-free bonds advisor might give to three common concerns.
What Are They?
The federal government has set up a system that allows city and county governments to get the working capital they need to undertake projects. Suppose a city wanted to add a subway line to connect a growing region with its center. They could, of course, just raise taxes, but that's unlikely to be a popular option, especially if most of the riders are expected to come from outside the city. An alternative is to do a bond issue to raise the needed capital.
How Does It Work?
Where the system of tax-free bonds comes into play is to create a market that helps both municipalities and investors. The lack of taxation of profits makes the bonds an appealing choice for investors.
More importantly, the market drives the bond rating and its returns to the investors. If a city has very good ratings, its bonds will return lower yields, but investors will have greater confidence they'll get their money back.
Conversely, cities with bad bond ratings can offer greater returns. In extreme cases, they can offer returns that guarantee more than 100% of the principal as profit. A city will still be able to raise money, but its cost of capital will be significantly higher. With something like an 8% yield on a 30-year bond, the city would have to default very early for the investor to not recoup most of the principal. In other words, it's all about pricing risk to return.
For the period from 1970 to 2011, only 0.8% of municipal bonds defaulted within 10 years. High-yield, and therefore high-risk, municipal bonds tend to do worst in bad economies, with the financial crisis of 2007 to 2009 being an especially bad time for bonds. Arguably, the 20 to 25% beating bonds this class of bonds took in late 2008 still pales in comparison to the poor performance of the stock market around the same time.
Assessing risk is important. It's wise to talk with a tax-free municipal bonds advisor to get a sense of what products are out there and how those investments might fit your appetite for risk.