- 1). Munis function much like other bonds. Except for zero-coupon bonds, municipal bonds pay a fixed sum each year called the coupon rate. The bonds have a face value (the amount the bond owner receives at maturity) but the price of bonds varies as they are traded. This means a municipal bond's effective interest rate (the yield) also varies. For example, if a $1,000 face value muni has a coupon rate of $60 (6.0 percent) but is trading at $900, the yield rises to 6.7 percent.
- 2). Prevailing interest rates are the most important consideration affecting the price and yield of municipal bonds. If interest rates rise, a municipal bond's price will fall so that the yield rises to match the new rates. A drop in interest rate has the reverse effect: bond prices rise. The other major consideration is credit risk. Municipal bonds are very safe investments, but they still carry some risk. The least risk is with AAA rated bonds. Lower rated municipal bonds have higher yields to compensate for the added risk.
- 3). Decide if you want to invest in a mutual bond fund or buy individual municipal bonds. A mutual bond fund has a couple of advantages. One is that your investment is in a diversified portfolio of bonds, reducing risk. The other is the portfolio is professionally managed. The disadvantage is that yields are lower because of the fees the fund charges. Before investing in a mutual bond fund, get a copy of the fund prospectus and examine the fund's performance history compared to similar funds. Compare the expense ratio of the fund to other funds (this is the percentage of the fund's assets that go toward management expenses). Be alert for any recent changes in fund management or terms that may affect the fund's performance.
- 4). Choose the type of municipal bonds you want to invest in if you decide to buy municipal bonds individually. Most municipal bonds are exempt not only from federal taxes, but also from local and state taxes. Taxable municipal bonds lack this feature but have yields that are comparable to corporate bonds. They may be your best choice if you are in a low tax bracket. Another option is the zero-coupon bond. These bonds do not pay an annual return. Instead, they are sold at a discount from their face value and the investor receives the full face value at maturity. For example, a zero-coupon bond with a 15-year maturity and a face value of $5,000 might cost around $2,500 when issued, with an average annual yield of around 4.8 percent.
- 5). Locate a bond dealer. Municipal bonds are not traded in a centralized exchange like stocks. Investors trade municipal bonds through more than 2000 banks, brokerage firms and other financial institutions that are registered with the Municipal Securities Rulemaking Board. Your bank may be one of these (especially if it's a large one), as are all of the major brokerage houses.
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