* State and local bonds purchased by local residents are generally free totally tax free.

How to invest in bonds?

Just as in stocks there are mutual funds that will do the job for you. They will pick the bonds for you and do the paper work and send you your interest cheque. If you don’t want your interest as yet they will reinvest it for you.

Mutual funds charge a small percentage amount out of your interest as fee. You do not have to pay commissions when you buy or sell also there are no other hidden charges. The approximate 0.25 percent you pay is for the professional management, record keeping and diversification.

What is the risk factor?

Bonds have a risk element in case you need your cash sooner than you expected. Since bonds come at a fixed rate of interest determining their market value is easy. The market value of bond can keep changing depending on interest rate fluctuations.

Suppose you have invested in a 10 year bond with 5% rate of interest. After two years you need the money for some reason. There are still 8 years to go till its maturity date. Lets say interest rates on 8 year bonds are 10% now. Why will anyone want to buy your bonds when he can buy new 8 years at a higher rate of interest? So you will have to sell at a discount and take a loss.

What is the alternative in case you need cash?

Money market funds would be best in this case. Money market fund is basically a bond mutual fund. The bonds in it are very very short term and very safe. You can take your money any time you want. In fact some of them allow you to write cheque on them. Of course there is a cost to this and that is that they do not pay much interest

Another money market fund is bank money market fund they are even safer, they offer insurance but as you know by now they pay even less interest rate.