Tax-free bonds are issued by public entities such as state and local governments. These so-called municipal bonds are free from federal taxes for all investors. Residents of the state in which a municipal bond is issued can also avoid state and local taxes. The tax-free nature of municipal bonds makes them of particular interest to investors in a high tax bracket.
When a municipality first sells a tax-free bond, it brings the bond to market in a manner similar to a stock initial public offering. A municipal bond underwriter -- the firm that assists the municipality in the bond offering -- brings the bond to market and sells it directly to investors. Before you buy a bond in the primary market, you'll have the chance to review the preliminary prospectus, which provides information about the issuing municipality and how the proceeds will be used. When you buy a municipal bond in the primary market like this, you may not have to pay any fees at all, as commissions are often subsidized by the seller.
The secondary market refers to the purchase of municipal bonds from dealers or other investors, rather than from the issuer in the primary market. Most large Wall Street firms have extensive bond departments and large supplies of tax-free bonds that you can purchase at any time. However, since regulation in the secondary municipal bond market is not nearly what it is in the stock or corporate bond markets, fees for secondary tax-free bond market purchases can be quite high. Since the bonds in the secondary market have already been issued publicly, you can review the final prospectus or bond circular to gather more information about a bond before you purchase it.
Municipal Bond Funds
For many individual investors, buying a municipal bond fund makes more sense than buying individual bonds. When you buy a municipal bond fund, you're buying into a share of municipal bonds selected by a professional bond manager on your behalf. If you buy a fund, you won't have to make decisions about the quality or characteristics of an individual bond you buy in the primary or secondary market. Many municipal bond funds are no-load funds, meaning you won't have to pay a commission to either buy or sell the fund.
While individual bonds have a maturity date at which you will be paid back your principal, bond funds do not mature. If you ever sell the fund, the price may be higher or lower than when you purchased it.
John Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to writing thousands of articles for various online publications, he has published five educational books for young adults.