The turmoil in the credit markets has made many investors nervous – but it has also created opportunities for those who are willing to consider municipal bond funds.
Municipal bonds are issued by state and local governments and agencies, such as counties, cities, schools and water districts. They’re used to finance public projects such as roads, schools and airports and certain private projects, including nursing homes and assisted living centers.
Traditionally, investors have purchased municipal bonds primarily because they offer tax-free income: The interest on municipal bonds is exempt from federal taxes, and because most states don’t require their residents to pay state and local taxes on interest received from bonds issued by political entities within those states, it may also be exempt from state and local taxes.
The Pre-Refunded Bond
Today, many investors are interested in a specific type of municipal bond called a pre-refunded bond, because these bonds offer additional benefits.
A “refunding” occurs when a municipality issues a bond at a lower rate to retire a bond that was issued earlier at a higher rate. In most cases, municipalities will spend the money raised by the new issue on government debt such as Treasuries and then, at a later date, use these securities to retire the older bond.
Why Consider these Bonds
Why consider municipal bonds that are candidates for refundings? First, these pre-refunded bonds are essentially backed by the federal government, but they generally offer a higher yield than do Treasuries. Second, if the municipality does cash the bond, the bondholder has received a yield that one might expect to receive from a longer-term bond for a short amount of time. As a result, prices for pre-refunded bonds usually rise.
Buying interest for these bonds is higher now than at any time since the early 1990s, and as a result, they may be hard to find. Your financial advisor can help you locate them.