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In the United States, municipal bonds are debt securities issued by state or local governments, called municipalities, to raise money. General obligation bonds and revenue bonds are the two main types of municipal bonds. Revenue bonds are sold to finance specific government projects. General obligation bonds are issued to raise money for a variety of needs like bridges, roads, and schools.
Local and state governments usually sell general obligation bonds at set times, called a schedule. These bonds are backed only by the government's ability to repay its debts. The government is called the bond issuer and the purchaser is called the bondholder. The purchase price is called the face value or the par value. General obligation bonds are long-term bonds that have maturity dates longer than one year.
General obligation bonds are sold with a fixed interest rate called the coupon rate. Regular interest payments are made to the bondholder until the maturity date. At maturity, the issuer pays back the face value to the bondholder. Sometimes the interest and face value are paid back to the investor at maturity in one lump sum. This type of bond is called a zero coupon bond.
A main benefit of purchasing municipal bonds is that the interest income is exempt from federal income tax. If a person buys a municipal bond issued in the state in which that person lives, interest income may also be exempt from state and local taxes. Since interest income can be tax exempt, general obligation bonds generally pay lower interest rates than other debt securities.
General obligation bonds can be purchased from a licensed securities dealer or through a mutual fund that invests in municipal bonds. Mutual funds help reduce risk further by including a variety of bonds from different issuers. Generally, it is easier for an individual to purchase bonds through a mutual fund. The dealer and the mutual fund manager may charge the investor commissions and management fees when bonds are purchased.
Municipal bonds are usually low-risk investments compared to corporate bonds or the stock market. Governments can raise taxes or take money from other revenue sources to pay the interest and par value owed to the bondholders. It is still possible for a state or local government to default on bond payments, causing investors to lose money.
To help determine the risk level of a particular general obligation bond, investors can check the bond's credit ratings. Companies that supply these ratings include Standard & Poor's (S&P®), Fitch Ratings, and Moody's®. Bond credit ratings are usually supplied at no cost to the investor.
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