Municipal Bonds

Reviewed: November 14, 2014
By FinanceWeb

What Are Municipal Bonds?

Municipal bonds are like any other bond, and it is a basic loan transaction. The investor makes a loan to the borrower for a guarantee to repay with interest. The loan takes the form of a bond with a face amount. The interest rate is the money the borrower pays to motivate the lender. The rate of interest on municipal bonds is referred to as the coupon rate. Investors can purchase municipal bonds directly from the local government issuers, and this is called the primary market. Long before the goals of the funds raised through the bonds have been achieved, the bonds can be sold by the initial purchasers. These sales are called the secondary market. The original price is a percentage of face value or par value. Depending on conditions, sales in the secondary market can be below par, at a discount or above par, at a premium.

Brief History of Municipal Bonds

Municipal bonds are a uniquely American form of public financing. They are bonds issued under the authority of state governments by cities or special public authorities like port, bridge and tunnel authorities. The maturities range from short, medium, and long term with higher interest tied to longer terms. They began in the early 1800’s as American cities took on new roles in the industrial era. They needed money to finance schools, roads, streets, public transportation, hospitals and many other public needs. Authorized by state authority and usually voted into existence by a public election, municipal bonds grew into a favored investment.

Recent history of Municipal Bonds

During the great crash of 2006-2008, municipal bond markets weakened because of the involvement of bond insurers in other problematic securities. Municipal bond insurers lacked capacity to handle new municipal issues. The municipal market recovered thereafter, and it improved further through the American Reinvestment and Recovery Act ( ARRA) which authorized federal subsidies to guarantee payment of local bond issues. At the end of 2012, municipal bond debt was approximately $3.8 trillion dollars.

The Basic Types of Municipal Bonds

General obligation bonds are municipal bonds backed by the taxing powers and credit of the state. States back these bonds by broad categories such as general funds. Revenue bonds are bond issues tied to particular sources of money such as highway tolls. Further differences include zero coupon bonds. This class of municipal bond does not have coupons or any periodic payment of interest. The principal amount and all of the interest are payable at maturity.

Advantages of Municipal Bonds

The primary advantages of municipal bonds are protection of principal and tax-exempt status of interest payments. The state’s authority backs general obligation bonds. Specific sources of revenue support repayment of principal and interest on municipal revenue bonds. Bonds can provide a regular source of income; many bonds bear coupons payable every six months. Another advantage is re-sale; municipal bonds can be sold to raise money to move to another investment. Some parts of bond income are taxable, for example, the amount gained on resale is taxable income.

Municipal Bonds and Balanced Portfolio

A balanced portfolio is one that hedges against some foreseeable risks. Investors seek to minimize the impact of economic cycles and events. Municipal bonds offer non-taxable income streams. As a rule, income or interest paid to investors is exempt from federal taxation. In most cases, it is also exempt from state taxes. Because one can sell them on the secondary market, long-term bonds with high yields have a place in a low-interest investment environment.