What Is A Municipal Bond? How Does It Work?

A Municipal Bond explained:

A municipal bond, also known as a muni bond (or muni), is a government bond issued by a local government or its agencies. The issuers of such bonds are governmental entities (or a group of governments) at or below the state level, including state governments, local governments, redevelopment agencies, municipalities, special-purpose districts, school districts, and suchlike that have one of these powers at hand: 1. The power of taxation 2. The power of eminent domain 3. The police power. The governmental entities issue muni bonds to finance their capital expenditures and projects, covering the construction and renovation of highways, bridges, schools, parks, roads, hospitals, neighborhoods, and other infrastructure.

In fact, they are loans that investors make to these public organizations. To put it in other words, if you buy municipal bonds, you are lending your money to the bond issuer in return for a promise of getting regular interest payments, also taking back your original investment (or the principal). A municipal bond’s maturity date (the time in which the bond issuer returns your original investment) may be years in the future (i.e., even more than a decade) or in one to three years.

There are 2 general types of municipal bonds: 1. General obligation bonds 2. Revenue Bonds

1. General Obligation Bonds are backed by the government’s taxing power. These bonds have the full faith and credit of the issuer, which has the power to tax residents to pay investors. These bonds are generally riskier and offer a higher yield.
2. Revenue bonds are backed by revenues from a specific project or source like lease fees or toll roads. The bonds’ yields depend on the amount of revenue collected from these sources.

How Does it work?

Municipal Bonds pay interest to their investors, usually twice a year. The bond issuers repay the principal on the bond’s maturity date. You can purchase municipal bonds directly from a registered municipal bond seller or indirectly through a municipal bond fund.

The municipal bond rates are determined at origination by these three factors:

1. They follow the equivalent Treasury bond rate. By the way, the bonds issued by the U.S. Treasury are considered to be among the safest in the world. Since munis have a bit more risk, they will pay slightly higher rates than federal bonds.

2. Municipal bond rates depend on the bond issuer’s credit rating as well. The highest is AAA. Since they are also the safest, they pay the lowest rates. Lower-rated bonds pay a higher rate to compensate investors for the greater risk of default.

3. It depends on the length of the bond, whether it is long-term or short-term. Long-term bonds (for example, 10 to 30 years) will pay more than short-term (i.e., less than ten years) bonds.

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The Pros of Municipal Bonds

1. Municipal bonds are more risk-averse and more focused on preserving than increasing wealth. The bonds provide a conservative investment in which your capital grows slowly and steadily.
2. Muni bonds are exempt from federal taxes and most state and local taxes. The interest rate can also be tax-free for the residents of that state.

*Note that municipal investments are not always tax-exempt investments. There are cases in which the income generated by a municipal bond may be taxable. For example, a municipality may issue a bond that does not qualify for federal tax exemption. So conducting a preliminary investigation about their provisions is a must for investors.

3. They are free to trade at any time once investors purchase them.

4. The U.S. municipal bond market is unique for its size, liquidity, legal and tax structure, and bankruptcy protection by the U.S. Constitution.

The Risks of Munis:

keep in mind that like any investment, municipal bonds entail risk;

1. Because of their relatively low risk, they pay low-interest rates than other investment strategies.

2. When interest rates decline, the bond issuer may repay a bond before its maturity date, which is called Bond call (or call risk). Many municipal bonds are callable; therefore, if you intend to hold a muni to maturity, before having that, make sure that you know well the bond’s call provisions.

  3. Credit risk (or default). The bond issuer may encounter financial problems in paying interest rates or returning the principal in full. Investors need to know that sometimes governments lack the ability or willingness to return their debts. Credit ratings try to evaluate the credit risk of a bond compared with other bonds; nevertheless, a high rating does not give a 100% guarantee that the bond will have no chance of defaulting.

  4. Inflation risk. Inflation will be a risk for bond investors who receive a fixed rate of interest. Fixed income falls behind with rising inflation.

  5. Liquidity risk. It refers to the risk that the bond investors won’t find an active market for their municipal bonds. Therefore, the market for the bond may not be liquid, and quoted prices for the same bond may differ.

  6. Interest rate risk. Market interest rates have inverse relationships with the value of a bond. Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond or other fixed-rate investments.

Conclusion

Muni bonds are an attractive option for investors in high tax brackets; because they offer various benefits, risks, and tax treatments. Additionally, they are very suitable investment strategies for risk-averse individuals who prefer preserving their wealth to increasing it.

Although municipal bonds are less risky than other investment strategies, remember that they are not supported by the federal government and can sometimes default. Because of the different types of municipal bonds available and the fierce competition among dealers to gain a piece of the business, you should enter into muni investing carefully and cautiously.

It is better to consult with your financial manager to find out –based upon your financial goals and needs- whether it is appropriate for you to purchase municipal bonds or not. For more information, please visit The Municipal Securities Rulemaking Board’s Electronic Municipal Market Access
website.

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NB: The purpose of this website is to provide a general understanding of personal finance, basic financial concepts, and information. It’s not intended to advise on tax, insurance, investment, or any product and service. Since each of us has our own unique situation, you should have all the appropriate information to understand and make the right decision to fit with your needs and your financial goals. I hope that you will succeed in building your financial future.