By Dominic Cellitti, Morgan Stanley Smith Barney - Houston

Municipal bonds, also called “munis,” are an investment tool many investors utilize and are becoming more popular, but before you choose to join that group, be sure you understand the bonds and their market.

This type of bond is issued by an entity of government: county, city redevelopment organization, school districts, public utility districts or other local governments or agencies. The bonds may be issued as either general obligation bonds or revenue bonds. General obligation bonds are

backed by the taxes paid to that entity, whereas revenue bonds are paid back through the revenue generated by the business backing the obligation.

A muni bond is basically a loan to the issuer in exchange for a set number of interest payments over a predetermined period. At the end of the period, also known as the maturity date, the full amount of the original investment is returned to the investor.

One of the popular reasons investors consider municipal bonds is due to the fact that interest income received from the bonds is often exempt from federal income tax and state income taxes, but keep in mind that the State of Texas does not have a state income tax. It is also important to

note that bonds issued for certain purposes may be subject to the alternative minimum tax.

If you are considering investing in municipal bonds, make sure you are aware of the current bond market as well as its tendencies.

The price performance of the municipal bond market has been anything but sedate in 2012. While it is true that much of the volatility has been courtesy of the US Treasury market, other factors unique to the municipal bond market, including supply, demand and other metrics, have made the tax-exempt bonds even more interesting.

Although tax-exempt bonds - such as municipals - are often “along for the ride” during bouts of treasury volatility, there have been noteworthy differences during this most recent swing, which is evidenced by a positive year-to-date total return for municipals versus a negative year-to-date

total return for treasury bonds, according to Barclays.

Increased volatility such as this, coupled with negative credit developments at the local level across the nation, continues to support a more tactical approach to what has historically been a much more sedate marketplace. This change requires a more prudent focus on issuer credit

quality for every purchase.

This credit quality rating for issuers ranges from “AAA” for those with the best rating, to “CCC” for those nearing default. A better rating indicates an entity’s ability to pay back their obligations to investors, so it is incredibly important to know this rating when making an investment.

It is important to know that bonds are subject to interest rate risk, credit risk and pre-payment risk. If sold prior to maturity, bonds may worth less or more than face value or than the amount originally invested.

Investing in municipal bonds can have a long term impact on your income stream and investment portfolio, but you must know the marketplace you are entering and the factors that are important considerations when making this type of investment.