If you are considering investing in bonds, you'll definitely want to consider municipal bonds (also referred to as 'munis'). Like other bonds, municipal bonds are a form of debt investment, meaning the purchaser (investor) is loaning the seller money. In return the investor is paid interest on his initial investment. When the muni reaches maturity (the date the loan is due to be repaid) he gets his original investment back and the interest payments stop.

Munis are issued by municipalities--state and local governments. The most notable feature of a muni is its tax-exempt status. In most cases the interest earned on a muni is not subject to federal tax. In addition, if the issuing municipality is in the state in which you live, it might not be subject to state or local taxation, either. Some munis may be subject to the Alternative Minimum Tax, so be sure to discuss that with your financial advisor first.

Munis fall into two categories: (1) general obligation bonds, or GO; and (2) revenue bonds. GO bonds are sold to help meet ongoing municipal operations. Revenue bonds are sold to help fund special projects like housing projects or airports expansions.

Both types of munis are generally considered safe. Municipalities can use tax income to repay GO loans. Property taxes, income taxes and sales taxes are commonly used. Revenue loans are usually repaid by income from the projects they are funding. Additionally, many munis are insured, guaranteeing the investor repayment.

Like all other bonds, munis are rated. Rating agencies like Standard & Poor's give them grades based in part on the issuer's credit rating. Grades range from AAA being the highest to c or D being the lowest. Munis can be rated high and be classified as investment grade or they can be rated low and be considered junk. Be sure to check the ratings on any munis you might be considering.

Munis typically pay a lower interest rate than taxable bonds. Don't let that dissuade you from considering them. In most cases the tax advantages outweigh the drawback of the lower interest rate. Again, be sure to discuss the specifics of the muni you are considering with your financial advisor.

There are two basic strategies for investing in munis. The first is to just buy them and hold them until they mature, collecting the interest paid along the way. The second is to create a bond ladder.

Creating a bond ladder involves buying bonds that have different maturity dates and different interest rates. As bonds mature the principal investment is used to purchase new bonds. The interest can either be reinvested into the ladder or not, whichever you choose.

There are some risks to be aware of before investing in munis. First, the interest is paid at a fixed rate. That means that even if overall interest rates rise, you are locked in at the comparatively lower rate you already agreed to.

There is also the risk that your muni could be called. That means the issuer can repay the muni before the maturity date. You get your initial investment back, but forfeit any further interest payments. Be sure to find out if your muni is callable before committing any money.

Overall, investing in munis is a good way to diversify your portfolio. They can keep your initial investment safe while at the same time providing you with a tax free source of income. Thoroughly research munis you may be interested in then discuss them with your financial advisor so you know exactly what you are committing yourself to before you buy.

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