Municipal bonds are basically loans from investors to state and local governments, and local government agencies. The biggest advantage of muni bonds is the interest that is paid to investors is exempt from Federal taxes, and could also be exempt from state taxes, depending on the state you live in and the type of bond that you buy. So if you are in a fairly high tax bracket, you should consider allocating a portion of your portfolio to tax free municipal bonds.
You have a couple options in terms of your investment vehicles. First you can buy municipal bonds directly. Bonds are in $5,000 denominations, but most firms have a minimum order size ranging from $15,000 to $25,000. Depending on the size of you portfolio, this could limit the amount of diversification you could have in muni bonds. However, the big advantage is that upon maturity, you will receive the par value back.
So if you buy a $5,000 bond, and interest rates rise, the value of your bond will drop, but eventually at maturity, you will get your $5,000 back.
The other option is by investing in municipal bond closed end funds, also known as CEFs. These funds own a diversified portfolio of munis. Yet, they are subject to interest rate risk. But there are a few other advantages to the CEFs besides the diversification. You can invest in much smaller amounts, as low as $1,000. Plus, they are much more liquid and trade during the day while the stock market is open.
Of course, you will want to go with the higher rated bonds in order to avoid the risk of default that we have seen recently in places such as Detroit, Michigan and Stockton, California.
A list of municipal bond closed end funds is available at WallStreetNewsNetwork.com.