If you follow financial news, you may have the heard the phrase "tax-free bond" used quite often. Some news reports discuss that investors are purchasing tax-free bonds in droves to take advantage of rising interest rates. What is a tax-free bond? Why would it be beneficial for the interest rate on these bonds to rise? Are there any risks in purchasing tax-free bonds? Do I need assistance managing tax free bonds? 

Tax-Free Bonds Defined

When the term "tax-free bond" is used, the kind of bond that is usually being discussed is a municipal bond. Municipal bonds are basically notes that a city, state, or county government issues for purchase on a borrowing basis. When an individual buys a municipal bond, he or she agrees to lend the government money, which it then uses to fund a current or future project. 

While the money is out on loan, the bond buyer is entitled to receive a flat interest rate as income. When the bond's maturity period ends, the government buys it back for the original purchase price. These bonds are considered tax free from the IRS because the purchaser does not have to pay taxes on the interest received after the purchase.

Types of Municipal Bonds

Municipal bonds are typically sold as either general obligation bonds or revenue bonds. A general obligation bond is not issued on the basis of collateral or guaranteed assets. Rather, the government issues general obligation bonds backed only by its history as a creditor and an understood assurance that it will buy the bond back at maturity. On the other hand, a revenue bond is backed by assets collected through government revenue projects such as toll fines or speeding tickets.

Benefits of Buying Municipal Bonds

The most obvious benefit of buying a municipal bond is that it can provide a simple, relatively low-risk way to increase taxable income. For the most part, state and local governments are excellent creditors that live up to their obligation to purchase the bond back at maturity, which can make it easy for bond purchasers to increase their current income (through the interest) and end up paying nothing out of pocket at all.

A second possible benefit of purchasing municipal bonds is that it is possible for a person to earn even more than originally expected. This happens when interest rates suddenly begin to increase. Since the purchase price of the bond is generally based on the current interest rate, an investor who purchases the bond when interest rates are low can end up earning much more if the interest rate rises during the maturity period.

Potential Risks of Purchasing Municipal Bonds

There are two major risks when buying municipal bonds: an interest rate decline and a government bankruptcy. Just as an investor can earn more if the bond's interest rate increases, he or she could see their earnings plummet if the rate goes down. On occasion, this happens after a purchase, resulting in a substantial loss.

The other risk is even less common, but is still a possibility. If the bond issuer goes bankrupt, the investors have no way to recoup the bond purchase price and may have to absorb the losses themselves. For this reason, it's important that investors carefully research the government whose bonds they intend to buy to look for any financial issues or concerns.

Buying tax-free municipal bonds can be a savvy way to increase an investment portfolio without increasing risk. The key is learning as much as possible about the economic standing of the related government so that you can avoid risk while you're in the market.