Conduit bonds may be issued for projects such as nonprofit hospitals, housing developments, colleges and universities, transportation hubs, student loan programs, and public works projects. The third-party borrower—not the issuing conduit agency—is responsible for interest payments and principal repayments. The issuing agency generally is not obligated to use any other source to repay the bonds if the conduit borrower fails to make loan repayments. So, unless the official statements indicate otherwise, investors in conduit bonds should not view the issuing governmental agency as a guarantor on conduit bonds.
While municipal bonds' coupons are often lower than those offered by similarly rated corporate bondsthe fact that interest income is tax-free can result in the yields being comparable, or even higher in some cases.
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Additionally, if you purchase original-issue municcipal bonds and hold them until their maturity date, those investments may receive special tax treatment under federal tax law. Although a municipal dorectly may be referred to as tax-exempt, there could be federal and state tax consequences when you buy, sell, or directlu the bond. Please see our section on Tax risks for more details. Default risk While municipal bankruptcies and defaults can and do occur, they have been relatively infrequent when compared to the corporate bond market. Historically, municipal bonds rated by a Nationally Recognized Statistical Rating Organization NRSROand in particular general obligation bonds, have experienced very low default rates.
For example, according to a Moody's study of U. Municipal Bond Defaults and Recoveries, 71 total defaults occurred over the period —, including only five general obligation bond issuers. In addition, under federal bankruptcy laws, a municipality must be specifically authorized by its state to file for protection, and the rules that govern a bankruptcy differ from state to state.
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Risks Interest rate risk Like all fixed income securities, the market prices of municipal munucipal are susceptible to fluctuations in digectly rates. If interest rates rise, market prices of existing bonds will typically decline, despite the lack of change in both the coupon rate and maturity. Bonds with longer maturities are generally more susceptible to changes in interest rates than bonds with shorter maturities. The retail order period typically lasts a couple of days and levels the playing field between retail customers and large institutions.
If you purchase a bond in the primary market, there are no fees or markups directlg the purchase. A bank or group of banks will bring the bond issue to the market and you would be required to have an account with one of the banks leading the new issue or with one of the banks that are syndicating the offering. New York City defaulted on its obligations in although investors were later made whole. The wise course of action is to spread your money around. Put only some of your fixed-income capital in municipal bonds; lend the rest to the U. Treasury and to corporations.
The muni bonds go in your taxable account. The rest should mostly go in your tax-sheltered account. If you live in California or New York you will be tempted to buy only home-state bonds in order to get a double tax exemption. Resist the temptation. The next level of sophistication involves the creation of a municipal bond ladder.
A ladder consists of a series of bonds, each with a different interest rate and maturity date. As each rung on the ladder matures, the vealuate is reinvested into a new bond. Both of these strategies are categorized as passive strategies because the bonds are bought and held until maturity. Investors seeking to generate both income and capital appreciation from their bond portfolio may choose an active portfolio management approach, whereby bonds are bought and sold instead of held to maturity. This approach seeks to generate income from yields and capital gains from selling at a premium. As the economy cools, interest rates fall, lifting bond prices.
You might think that bonds are a great buy during boom times when prices are lowest and a sell when the economy starts to recover. In addition to cyclical changes, interest rates may go through longer-term shifts.
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Since the early s, U. Interest rates have seen lower cyclical highs and lows. Investors buy numerous bonds that mature across a period of years. As bonds mature, the principal is reinvested and the ladder grows.
Laddering effectively diversifies interest-rate risk, though it may come at the cost of lower yield. Investing in bond funds The challenge of buying individual bonds is that investors need to vet each individual issuer. That's why many investors prefer to put their money into bond funds. With a bond fund, investments are pooled into a single bucket and are used to buy various bonds. The benefit of bond funds is that they offer diversification within the bond market. Imagine you buy bonds from a single issuer, and that issuer defaults. Suddenly, you're out of luck. But if you own a fund that's invested in many bonds, and only one defaults, the impact won't be nearly as severe.
On the flip side, bond funds are subject to the same interest-rate risk we talked about before. The bottom line on bonds Though there's a downside to buying bonds, in many cases, bonds can be a solid addition to your portfolio. It pays to explore your options for investing in bonds so that you can reap the various benefits they offer, both now and in the future.