Municipal Bonds

Municipal bonds are bonds that are issued by state and local governments. The quality of these bonds is rated based on the bond issuer's ability to make their payments-their credit record-by independent agencies, such as Standard and Poor's, Fitch Group and Moody's Investor Services. The municipalities are given letter grades, with AAA (or Aaa, in Moody's case) being the best rating.

What do these letter ratings mean? An AAA bond is considered the safest bond investment in terms of risk. This makes sense because the bond ratings are based on the state or local government's credit record and financial strength. So why would an investor choose to buy a bond rated CCC, rather than AAA? Well, as with most investments, the riskier bonds pay interest at a higher rate. An investor must consider his or her own age and stage in life and the level of risk he or she can tolerate as well.

Municipal bonds, unlike other bonds, such as corporate bonds, are an investment with an added tax bonus. The interest earned on municipal bonds is not subject to federal tax. In addition, if you're a resident of the state or locality that issues the bonds, the interest is generally not subject to state and local income tax. Because of this attractive tax feature, municipal bonds often pay interest at rates lower than other types of bonds. However, if you are in a certain tax bracket, your tax savings may offset the lower interest rate paid by municipal bonds.