What is a Municipal Bond?
A municipal bond refers a bond or fixed income security that is issued by a government municipality, township, or state to finance its governmental projects. Municipal bonds are also referred to as “muni bonds” or “muni.”
The advantage of municipal bonds for investors is the fact that they are tax-exempt, meaning that the returns from such bonds are not subject to taxes. It makes it a highly attractive investment for individuals who are in a high tax bracket.
What is a Bond?
A bond is a fixed income or debt instrument that essentially allows an investor or lender to provide money to a borrower in the form of a contractual arrangement. Bonds are typically issued by government entities or corporations to finance their projects and operations.
The specifications of a bond include details such as:
- Maturity date
- Face value
- Issuing price
- Stated interest rate (coupon rate)
- Coupon dates
- Amortization details
- Embedded options
The prices of bonds are set by the market interest rate and the credit risk of an issuer. Bond prices and market interest rates are inversely related, so if the market interest rate goes down, the prices of bonds go up since their inherent stated interest rate remains the same. Conversely, if the market interest rate goes up, the prices of bonds decrease since their inherent stated interest rate is less attractive.
In addition, the credit quality of issuers can influence the stated interest rate or the prices of bonds. If an issuer is of poor credit quality and is more likely to default, then they will typically come with a higher stated interest rate to compensate for the additional risk that they pose.
Government entities typically are of very little credit risk, especially the federal government, since they can theoretically print off any money they need to service any debts. Municipal governments generally are very low risk, but it is not unheard of for a municipal government to default on a bond.
Specifications of bonds can vary significantly and can be tailored to the investor. It can include special characteristics such as:
- Zero-coupon – No coupon payments over the life of the bond.
- Convertible bonds – The bond is convertible into a stock at the discretion of the investor.
- Callable bonds – The bond can be
called” back at the discretion of the issuer.
- Puttable bonds – The bond can be “put” back at the discretion of the investor.
Uses of Municipal Bonds
Municipal bonds are bonds that are issued by municipal governments typically to fund municipal projects, such as:
- Construction of schools
- Construction of libraries
- Construction of infrastructure (roads, bridges, public transit)
- Funding police departments
- Funding fire departments
- Building parks and pathways
- Funding community centers
- Funding waste management
Types of Municipal Bonds
Municipal bonds are classified by the interest payments and principal repayment schedules. They are structured in various ways, providing different tax benefits and tax treatments. The income generated by a municipal bond is generally tax-free, which makes it very attractive for investors in high tax brackets. However, some forms of municipals bonds are not tax-exempt.
There are two general forms of municipal bonds:
1. General obligation bond
General obligation bonds are issued by government entities and are unsecured by revenues from a specific governmental project. Therefore, the bonds are generally riskier and provide a higher yield.
2. Revenue bond
Revenue bonds are issued by government entities and are secured by revenues from a certain government project. It can be in the form of tolls or taxes, such as sales tax, property tax, etc. However, the bonds’ yields can fluctuate depending on the amount of revenue collected from the sources.
Risks with Municipal Bonds
Although municipal bonds are fairly safe bonds with little default risk, they are not backed by the federal government and can default from time-to-time. That being said, municipal bonds are still a much safer alternative to corporate bonds.
Municipal bonds typically carry a call provision. A call provision allows the issuer to redeem the bond before the maturity date. It poses a risk to the investor since they will not receive any additional interest after the bond’s been called.
Issuers will elect to use a call provision when market interest rates are low. It is because they can pay off a bond with a higher interest rate and reissue a new bond with a lower interest rate.
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