What are municipal bonds?
If you are a novice investor, you may have various questions concerning what are municipal bonds. The pupose of this post is to provide general information relative to answering this question. It is being provided for educational purposes only. Thus, is it not designed to be complete in all material respects. Therefore, this post should not be relied upon for legal or investment advice. If you have any questions concerning the below summary, you should contact a qualified professional.
Municipal bonds are debt securities issued by states, cities, counties and other governmental entities to finance capital projects, such as building schools, highways or sewer systems, and to fund day-to-day obligations. Investors who buy municipal bonds are in effect lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or “principal.” The date when the issuer repays the principal, the bond’s maturity date, may be years in the future. Short-term bonds mature in one to three years, while long-term bonds won’t mature for more than a decade.
Benefits to investors in municipal bonds include the fact that interest on such bonds generally is exempt from federal income tax and may also be exempt from state and local taxes for residents in the state where the bond is issued. Given the tax benefits, the interest on municipal bonds is usually lower than on taxable fixed-income securities such as corporate bonds.
The two most common types of municipal bonds are general obligation bonds and revenue bonds:
General obligation bonds are issued by states, cities or counties and not secured by any assets; instead, they are backed by the “full faith and credit” of the issuer, which has the power to tax residents to pay bondholders.
Revenue bonds are not backed by government’s taxing power but by revenues from a specific project or source, such as highway tolls or lease fees. Revenue bonds usually are non-recourse, meaning that if the revenue stream dries up, the bondholders do not have a claim on the underlying revenue source.
In addition, municipal borrowers sometimes issue bonds on behalf of private entities such as non-profit colleges or hospitals. These “conduit” borrowers typically agree to repay the issuer, who pays the interest and principal on the bonds. In cases where the conduit borrower fails to make a payment, the issuer usually is not required to pay the bondholders. Recently, many municipalities also began to issue taxable Build America Bonds and other taxable municipal bonds with associated tax credits or direct federal payments to the issuer that were authorized by the American Recovery and Reinvestment Act of 2009.
Individual investors hold about two-thirds of the roughly $2.8 trillion of U.S. municipal bonds outstanding, either directly or indirectly through mutual funds and other investments. Bond investors typically are seeking a steady stream of income payments, and compared to stock investors, they may be more risk-averse and more focused on preserving rather than accumulating wealth.