But for investors who understand how Ginnie Maes work, getting principal back monthly can be a big advantage. By reinvesting this monthly return of capital — not spending it — the compounding effect can boost the total return above that provided by the Ginnie Mae itself. Some advisors, in fact, can arrange for their clients to receive only the interest each month, keeping the principal portion in an interest-bearing account on behalf of the investor. Not all financial planners or brokers perform this service; you’ll have to ask.
But if you’re buying Ginnie Maes, that’s the smart way to treat them.
If bonds issued by the United States Government are the safest investment, then it follows that bonds issued by state governments are the second-safest. Known as municipal bonds (muni’s) because they are issued by state and local municipalities, they have been a primary source of capital for state and local governments since colonial days.
There are two types: General Obligation and Revenue.
G.O. bonds are guaranteed by the government issuing the bond; revenue bonds are not guaranteed.
Typically, G.O. bonds raise money for schools, highways, and other public works which do not generate revenue, while revenue bonds normally are used for projects which do, such as toll roads, airports and hospitals. Revenue bonds rely on the notion that revenue from the project repays the bond’s interest and principal. But if the project fails to raise enough revenue, you will not be paid. Thus, revenue bonds are subject to default risk, while G.O. bonds are not. If you’re primarily concerned with safety, you should choose a G.O. bond over a revenue bond.
Municipal bonds are extremely popular. The reason is because all the
interest you earn is free of federal income taxes. Of the four enemies
of money, muni’s beat one of them: You don’t have to pay taxes to the
federal government and, in 26 states, if you buy a bond from the state
in which you live, you don’t have to pay state income taxes, either.
Why is the interest earned on a municipal bond free from federal
income tax? Why is Uncle Sam willing to give up the tax revenue?
The answer is provided by the courts. In the 1800s, Maryland sued
the federal government, arguing that the feds were taxing the states
on revenue the states were earning — in essence, an income tax on
the states. The Supreme Court ruled (with one of my favorite quotes)
that “the ability to tax is the ability to destroy.” (Really? Gosh!)
The high court recognized that if the federal government taxed the
states on their income, the states would retaliate by assessing property
taxes against the fed for post offices and military bases. In other
words, the two governments simply would tax each other endlessly.
To preserve our federal system, the Supreme Court ordered the two
to stop. The federal government, said the court, may not tax state
obligations and the states may not tax federal obligations. Since
municipal bond interest is an obligation of the state (hence the name
“General Obligation”), Uncle Sam cannot tax that revenue. Thus,
there is a legitimate reason why muni interest is tax-free.