What are municipal bonds?
In order to understand what municipal bonds are, it helps to break up the term. Simply speaking, bonds are IOUs. You, the investor, purchase a bond knowing that the party you purchase it from will owe you a predetermined amount of money at a predetermined time in the future. In effect, you are lending your money, in exchange for a return in interest. A municipality is any locality that is headed by an organized government (i.e. cities, states, and countries). Therefore, a municipal bond is an IOU instrument that is tendered by a government.
What's the risk?
The risk is relative to the entity you purchase your bonds from. As the investor, it is your responsibility to investigate the credit worthiness, political philosophy, and overall economic stability of the issuing government. For example, it is probably not a good idea to purchase bonds from a government that appears to be teetering on bankruptcy, no matter how great the interest rate.
Different types of municipal bonds.
There are two types of municipal bonds: general obligation (GO) and revenue bonds. General obligation bonds guarantee their interest payments through the government entities they are issued by. Governments use funds incurred through these municipal bonds are used to finance projects (road repair, school system upgrades, etc.). Revenue bonds are issued by government-backed entities, such as water and electric companies. The entities issuing these bonds use the funds they incur to finance operating costs, and pay back the interest using corporate revenues.
Tax-free or taxable bonds? You will have to choose between either tax-free municipal bonds, or taxable (sometimes called tax equivalent) bonds. Taxable bonds can yield much higher interest rates, but they are also taxed at your current tax bracket rate; tax-free bonds, on the other hand, yield lower interest rates. In order to figure out if you'd fare better with tax-free or taxable bonds, simply calculate the amount the taxable bond would cost you versus the amount it would yield you and compare that to the yield of the tax-free bond.
Municipal bonds can be a safe and lucrative investment, but you must do your research and ensure that you know exactly what type of investment you are getting into, as well as what your risk is. Fortunately, there are many resources out there to help you reach those conclusions, whether you choose to combine them with dividend stocks in your portfolio or simply focus on bonds alone. Be sure to surf the web and visit your local library before you make this investment.