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How To Avoid The Traps of Investing in Municipal Bonds

By Jason Markum

I will be the first person to tell you that investing in the stock market is really really hard. Many speculators will have you believe that investing can be easy; that you can just push a few buttons on your computer to pick a few stocks and make a bunch of money, but I think we both know better than that!

Some people think that investing in bonds is a safer bet than investing in the stock market; and for the most part, they are right. But there are some traps that you can get sucked into, especially in the municipal bond market and that is exactly what I want to talk about in this article today.

Someone once told me that there is no such thing as a really bad bond… as long as you find one at the right price! I suppose that’s probably true, but it begs the question… what is the right price?

Investing in municipal bonds can be tricky because it is often hard to determine what the correct price should be. Generally speaking I find that bond valuations confuse the heck out of the average investor because unless you’ve taken an advanced finance or economics class in bond pricing, then the math may be beyond you.

What is so enticing about municipal bonds is that many municipalities offer relatively high tax exempt yields and so you really should have some of them in your investment portfolio no matter what.

But don’t get lulled into a false sense of security, as these types of bonds have significantly higher risk than your regular money market account even though they are simply stodgy old bonds. As far as risks go, they are much riskier than regular US government bonds because US bonds are backed by the full faith and credit of the United States Treasury whereas municipal bonds aren’t backed up by much of anything. And yes municipalities do go bankrupt all the time so you have to be careful.

Here are some other risks that are involved that you may not have thought about for munis.

The first risk is the same risk that all bonds hold, and that is the interest rate risk. With bonds, when interest rates rise – the market value of the bond falls because bonds have an inverse relation between yield and price. When price goes up, the yield goes down, and when the yield goes up price goes down.

The next risk is default, as I already mentioned. Yes it is true that defaults are not very common… but the fact remains the same, defaults can and do happen especially in times of recession like we are currently in right now in 2010.

Finally, many brokers simply don’t specialize in municipal bonds and may steer you the wrong way. Check to see if your stockbroker has a specific musical bond department and if so only deal with them. If they don’t, consider finding a firm that specializes in municipal bonds just for that portion of your portfolio.

Yes, there are risks in municipal bonds but the tax advantages and the higher yields will usually outweigh those risks. As with any investment opportunity, be sure to do your homework before you make an investment decision.

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