We Know: How Municipal Bonds Work

What are municipal bonds?

Municipal bonds, or munis for short, are issued by governmental agencies (state, city, or local governments) as a method of issuing debt through public investments. Essentially, you lend money to the issuer (i.e. the government) who promises to repay you the principal plus a fixed or variable amount of interest. This allows government agencies to fund public interest projects for which they do not have immediate funds at their disposal, such as building or updating schools, highways, housing facilities, and other public works projects. Municipal bonds are guaranteed by the government agency of issue.

How do municipal bonds work?

The city, local, or state government entity that issues the bond sells it directly to investors at the time of issuance, receiving cash payment in return from the investor. The issuer promises to repay the investor at some future date, usually with interest. When the issuer pays depends on the terms of the contract. The interest is usually determined at a rate lower than market value for privately funded projects. As required by law, money collected from the sale of the bond must be spent at one time on the intended capital project, or spent within three to five years from the time the bond is issued. The investor, as bond holder, receives periodic interest payments on the principal invested until the bond matures, or receives both interest and payment in one lump sum when the bond reaches maturity. The interest that is received by the bond holder may be tax-exempt, although this will depend on the type of project funded.

What are the different types of municipal bonds?

Municipal bonds come in two different flavors. Short-term municipal bonds, which mature in less than a year, include:

  • Bond Anticipation Notes (BANs) - used to finance projects while long-term financing is being secured.
  • Tax and Revenue Anticipation notes (TRANs) - used to finance projects in anticipation of future tax revenues.

Long-term municipal bonds are used to finance capital projects that will last more than one year. Long-term munis that are tax-exempt include:

  • General obligation bonds - the issuer promises to repay the principal and interest in full faith. These bonds are approved by voters and are the most secure of the municipal bonds. They generally have low interest rates.
  • Revenue bonds - repayment depends on revenue obtained from toll, charges, water utility payment by customers, and rents received from state-owned facilities. These bonds are issued by special agencies.
  • Assessment bonds - repayment depends on the income received from property tax assessments within the locality of the bond.

Private activity bonds are issued by the government to benefit private parties. These long-term bonds are not exempt from income taxes.

Are municipal bonds a safe investment?

Municipal bonds are a highly sought after investment because of its tax-exempt status. Whether or not it is a safe investment depends on its ratings. Before the bond is issued, an independent risk rating agency determines the likelihood that the government entity will be able to satisfy the obligations of the bond. Any bond that receives a BBB, Baa, or better rating from these third-party agencies is considered a sound investment.

Bonds receiving AAA-ratings are fully insured by the issuing agency. These types of bonds normally make periodic interest payments to their investors.

A zero-coupon municipal bond is slightly higher risk bond, and payment to the investor occurs at one-time upon the maturity of the bond.

The interest rates and bond yield depend on the ratings risk of the issuing agency. In general, a high interest municipal bond results high yields. Lower interest rates results in a lower-yielding product.

Are there tax benefits to investing in municipal bonds?

Income generated from the purchase of municipal bonds may be exempt from federal, state, or local income taxes, depending on intent of the bond. Bonds issued for projects intended for the common good are classified as tax exempt. Bonds that fund projects intended for the benefit of private parties are not considered tax exempt. Tax-exempt bonds generate lower yields than non-exempt bonds.

Where do I purchase municipal bonds?

Municipal bonds may be purchased over-the-counter, or at any securities firm registered with the Municipal Securities Rulemaking Board (MSRB). Investors may obtain municipal bonds from over 2,700 MSRB-approved securities dealers across the country.

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