Lenders & Advisors

Municipal Bonds As Secure Investments

January 25th, 2013
Financial stability is a goal that should be high on any investor's list. One source of stability is diversification.
The diversified portfolio

A basic concept of sound investment strategy is the diversification of the investment portfolio. Financial stability is a goal that should be high on any investor's list. One source of stability is diversification. The process of diversifying a portfolio involves placing assets in distinct classes or "buckets" of investments. The choices are between assets that have different reactions to various market conditions. One class may be sensitive to an increase in the rate of inflation, such as precious metals. That investment would be balanced by another class that thrives in low inflation economies, such as high-growth equities. A classic dividing line in the discussion of diversification always addresses the contrast between bonds and stocks.

Risk versus reward

The economic principle of risk versus reward is fundamental to investing. A simplistic statement of the principle is that an investment that represents a higher risk should earn a higher return. And, the alternative, lower risk justifies a lower return. The art and science of investment strategy is invariably centered on finding a balance between true risk and true return. The qualifier "true" is used because it is not easy to know what the actual risks are or what the final return will be.

The benchmark to all investment returns

At the current time, all investment risks and returns are measured against the rates for U.S. government bonds. The presumption is that there is as close to zero risk as possible in such an investment. Every other investment choice will represent a higher risk and command a higher return. That is why a corporate offering of debt will be a multiple of the rate on U.S. debt. Likewise, a so-called junk bond will command an even higher multiple to reflect the higher risk.

Local governments and risk

Most state, county and city governments issue some form of debt. These are referred to as municipal bonds. These bonds are backed by one of two methods. The first is as general obligations of the respective governmental entity. These bonds are guaranteed by the total taxing authority of the entity. The second type is revenue bonds. These debts are backed by a specific source of revenue, such as a sports stadium.

Many people see municipal bonds as relatively risk free. As a result, many of the rates earned on general obligation "munis" are only slightly higher than U.S. rates. Because of their tax-exempt status, the effective rate of return attracts many investors seeking financial stability in a portion of their portfolio.

An investment adviser can provide valuable insights into how bonds can be an important component of a diversified portfolio.

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