Although a municipal bond may be referred to as tax-exempt, there could be federal and state tax consequences when you buy, sell, or own 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 NRSRO , and 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.
Interest rate risk Like all fixed income securities, the market prices of municipal bonds are susceptible to fluctuations in interest 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. Call risk Many municipal bonds carry provisions that allow the issuer to call or redeem the bond prior to the actual maturity date. An issuer will typically call bonds when prevailing interest rates drop, allowing the entity to re-issue bonds at a lower borrowing cost.
In this circumstance, the action makes reinvestment less desirable for the holder. Some municipal bonds, including housing bonds and certificates of participation COPs , may be callable at any time regardless of the stated call features. In some cases, bond issuers will call bonds to modify an indenture through a new offering. Investors should also be aware of special or extraordinary redemption provisions. These are provisions that give a bond issuer the right to call the bonds due to a one-time occurrence, such as a natural disaster, interruption to a revenue source, unexpended bond proceed, or canceled projects.
Liquidity risk The vast majority of municipal bonds are not traded on a regular basis; therefore, the market for a specific municipal bond may not be particularly liquid. This can be attributed to the large number of municipal issuers and variety of securities. With limited exceptions for some large more actively traded issues, the chances of finding a specific municipal bond in the secondary market at any given time are relatively small. According to the Municipal Securities Rulemaking Board MSRB , it is much more common to identify basic characteristics of a municipal bond in which an investor is interested in investing e.
Selling prior to maturity can present a challenge for municipal bond investors due to the fragmented and thinly traded nature of the market. Revenue sources risk With revenue bonds, the interest and principal are dependent on the revenues paid by users of a facility or service, or other dedicated revenues including those from special taxes. In general, the consumer spending that provides the funding or income stream for revenue bond issuers may be more vulnerable to changes in consumer tastes or a general economic downturn than the income stream for general obligation bond issuers.
For example, a facility that delivers fundamental or essential services, such as water and sewer, may be more likely to have dependable revenues through multiple economic cycles. When evaluating revenue bonds, it is important to consider:. Credit and default risk Credit risk is the risk that the issuer will default or be unable to make required principal or interest payments.
Despite the fact that many municipal bonds have high credit ratings, there is a risk of default in any bond investment.
Definition of Zero Coupon Obligation
Tax risks While municipal bonds can offer attractive effective yields and can be a way to generate tax-free income, they may not be right for investors in every tax bracket or for every type of account. For instance, a portion of the income you receive may be subject to the federal alternative minimum tax, even if that income is classified as tax free. Also, once you sell a municipal bond, the proceeds from that sale may be subject to capital gains or other types of taxes.
With capital gains taxes, your earnings are taxed at either the current capital gains tax rate or your ordinary income rate, depending on how long you hold the bond. You may also be taxed on gains characterized as market discount at your ordinary income rate. Market discount arises when a bond is purchased on the secondary market for a price that is less than its stated redemption price. Finally, it's important to remember that tax laws may change. So the favorable tax conditions that existed at the time you purchased a bond may be either phased out or no longer available to investors in your tax bracket.
Please consult your tax advisor before purchasing any security. Repudiation risk There can be no assurance that bonds validly issued will not be partially or totally repudiated by the issuing state or municipality, should that be deemed reasonable and necessary to serve other important public purposes. A muni opportunity. View all fixed income articles. Fidelity Learning Center. Fixed Income Glossary. It is also a list of the maturity dates on which individual bonds issued as part of a new issue municipal bond offering will mature. Skip to Main Content. Search fidelity.
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Why Fidelity. Print Email Email. Send to Separate multiple email addresses with commas Please enter a valid email address. Your email address Please enter a valid email address. Message Optional. Municipal Bonds Municipal bonds are debt obligations issued by public entities that use the loans to fund public projects such as the construction of schools, hospitals, and highways. Reasons to consider municipal bonds Interest income generally federally tax exempt Low level of default risk relative to other bond types.
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Get updates on new issue or secondary municipal bonds sent to your wireless device or Fidelity. Sign up for alerts. From our experts A muni opportunity View all fixed income articles. Fidelity Learning Center Gain a deeper understanding of fixed income and bonds. This high duration means that these bonds' prices are particularly sensitive to changes in the interest rate, and therefore offset, or immunize the interest rate risk of these firms' long-term liabilities.
Alternatively, when purchasing a zero coupon bond issued by a U. Zero coupon bonds were first introduced in the s, but they did not become popular until the s. The use of these instruments was aided by an anomaly in the US tax system, which allowed for deduction of the discount on bonds relative to their par value. This rule ignored the compounding of interest and led to significant tax-savings when the interest is high or the security has long maturity.
Although the tax loopholes were closed quickly, the bonds themselves are desirable because of their simplicity.
In India, the tax on income from deep discount bonds can arise in two ways: interest or capital gains. It is also a law that interest has to be shown on an accrual basis for deep discount bonds issued after February From Wikipedia, the free encyclopedia. This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed.
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