How Do Municipal Bonds Work?


You might be wondering:

Why does our government need to issue bonds?

The reason is simple:

Governments or government institutions sometimes find that they do not have enough money for certain civic projects. 

They often issue municipal bonds (munis) to raise the required funds quickly and supplement their budgets for the public projects.The different government agencies and institutions that issue these bonds are:

  • States
  • Towns
  • Cities
  • Counties
  • School Districts
  • Hospitals
  • Transportation Authorities
  • Colleges and Universities
  • Housing Authorities
  • Road and Highway Authorities
  • Water Districts
  • Power Districts

What Are Municipal Bonds?



Municipal bonds are certificates of indebtedness issued by states, cities or other local governments to raise funds.  Traders and investors have nicknamed them ‘munis’.  Government entities fund projects such as road repairs, purchase of open land, upgrade of systems, etc. through these bonds.  They are naturally attractive because they often come with security and tax benefits.  For example, many municipal bonds provide federal tax-exempt interests.

How does it work?

Municipal bonds are still debt securities issued by these organizations to bondholders.  Simply put, the bondholders are lending money to the bond issuer through a loan evidenced by the bond.When the bond maturity date comes, the holders expect to be paid back the face value of the bond. The bond becomes due and payable on the date stated on the bond.The amount of the bond when it was issued is called the face value.  It is also known as the par value.

To entice investors to lend money through the bonds, the issuers offer to pay interest on the bonds.  The Federal and State governments usually exempt these interests from federal and state taxes, respectively.  The issuer commonly pays the interest every six months until the bond’s maturity date. By then, the government agency will repay the bondholders the amount of money represented by the bonds.

Main Features Of Municipal Bonds

The bonds will usually come with a coupon. Originally, the coupon was a detachable portion of the bond that bondholders used to collect the interest.  Now, the term ‘coupon’ is widely used to denote the annual interest rate paid on a bond.  The rate is a percentage of the bond’s face value.

Many investors do not buy an initial issue of the bond at its face value.

They usually scan the bond market for municipal bonds that are not selling at par value.  The price of the bond is the value of the bond bought and sold at a given period of time.  The price of a bond could also go higher or lower than its actual face value.  This will depend on several factors including the state of the economy and market conditions.  The price of a bond is expressed using cents on the dollar.

For example, if a $10,000 bond were selling for $9,700, its price would be quoted as 97.

Consider the YTM

The bond’s yield or yield-to-maturity (YTM) is important information for investors.  It is a calculation of the total interest plus principal that would accrue if the investor keeps it to maturity.It takes into account the amount paid for the bond plus interest until the maturity date.  Investors pay more attention to the yield than on the interest rate or coupon.  Bondholders can see through the YTM how much amount they will get later so they can make better cash projections.

Municipal Bonds – How Do They Work?

There are two popular types of munis:

The first is called the General Obligation (GO) Municipal Bonds and the other is the Revenue Municipal Bonds.




General Obligation Municipal Bonds rest on the issuing municipalities’ authority to tax its constituents.  This is quite popular in the US.  GO bonds are issued by tiny towns and big states alike.  Big and small investors, new and veteran traders, buyers from small counties to big states – everyone finds these bonds worthwhile.

GO bonds are usually issued to fund public work projects such as new schools or sewer systems.

GO munis are considered a safer bet than Revenue munis.

Why?

GO bonds are not earmarked against revenues from a specific project even if they are issued by government entities. So while GO bonds may be issued to fund a toll road, repayment funds may not come from toll fees. Some GO bonds are secured by dedicated real property taxes while others by general funds.  The latter types are described as “backed by the full faith and credit” of the issuing government entity.

It is generally assumed that entities that issue GO bonds have unlimited authority to impose taxes in order to repay the debt.  However, there are also cases where the issuing government entity has limited or zero taxing authority.

Types Of GO Bonds

There are actually two sub-types of GO bonds:

  • Unlimited Tax General Obligation Bonds
  • Limited Tax General Obligation Bonds.

With Unlimited Tax GO bonds, the issuer pledges to raise taxes without limit for the purpose of servicing the bond debts.  They have a broader taxable base because the issuer can use property taxes, sales taxes or other ad valorem taxes.

Limited Tax GO bonds differ because the issuer commits to raise taxes only up to a certain level.  For example, a small county decides to build a county hospital and issues a Limited Tax GO bond.  The residents might agree to a 1.5% increase in medical services tax for the next 3 years so the county can pay off the bond.  Here, it is clear where the repayment money will come from.  In a small county with fewer residents, the taxable base is much narrower than with an Unlimited Tax GO bond.

Revenue Municipal Bonds

Revenue Municipal Bonds can be issued by any government agency that is managed like a business.  Examples would be the local water district or a public transportation authority. The entities must have their own operating revenues that match against their operating costs.

A specific revenue source is used to secure the bonds.  This will come from the project that the bonds will finance.  This means that the money to pay off the bondholders will prospectively come from the income of the project it will finance.

For example:

A town might issue revenue bonds to finance the construction of the local stadium.  The town officials will use the rental income of the stadium to pay off the bondholders.  Similarly, the officials will use whatever other income the project generates to retire the bonds that funded them.

Revenue bonds may be issued by the following:

  • Not-for-profit organizations
  • Corporations in the private sector such as colleges, universities & hospitals
  • Public service entities such as water utilities and transport authorities

Who Invests In Municipal Bonds?

The Federal Reserve lists down the most common holders of municipal bonds. They are:

  • Individual investors
  • Mutual funds
  • Money market funds
  • Life insurance companies
  • Non-life insurance companies (property and casualty)
  • Closed-end investment funds
  • Commercial banks
  • Foreign investors

Over the last decade, these holders have been increasing their investments in municipal bonds.  In a shifting economic situation, it is a good strategy to invest in a much safer option to protect your wealth.  The market perceives municipal bonds as one of the safest investment choices.

1M Bonds,  $3.7 trillion Principal

According to the SEC, there were over one million different outstanding municipal bonds as of December 31, 2011.  They combine for an aggregate principal amount of more than $3.7 trillion.  Individual investors hold some $2.78 trillion of the total.  The most prevalent investors of municipal bonds are high net worth individuals in the upper income tax brackets.

These people were most likely attracted to the tax-exempt status of these securities.  These types of investors also favored the steady income of the bonds over the rate of return.  This behavior significantly points to the baby boomer generation as the most common investors in municipal bonds.

How Can You Buy Municipal Bonds?



The easiest way to purchase a municipal bond is through an investment broker.  You might be able to find a broker who specializes in bonds but any stockbroker will do.  They will typically charge a transaction fee from 0.5% to 3% of the purchase price.  The minimum amount you can purchase is usually $5,000 and goes up in $5,000 increments too.

There are two simple ways to invest in municipal bonds:

  • You can purchase the bonds directly through your broker. 
  • Second, you can buy a mutual fund that invests in municipal bonds.

Let’s explain:

In the first, you can buy an individual municipal bond through bond dealers, banks, and brokerage firms.  In some cases, you can purchase straight from the municipality.

In the second, you simply buy shares in the mutual fund through a traditional or online broker or directly from the mutual fund company.  Mutual bond companies offer professional management of a bond portfolio.  The fund manager would study, select, and purchase bonds for the mutual fund.

Advantages Of Municipal Bonds

So we’ve already seen a lot of advantages of municipal bonds. They are tax-exempt.  They are great diversifiers of your portfolio.  They are also reasonably a very safe investment.  However, those are not just the advantages.  Some municipal bonds have a higher yield compared with other fixed-income instruments.

Municipal bonds registered YTM rates of as high as 4.04% in July 2017.  The highest annual yield for CTDs for the same period is only 2.70% and for a 30-year Treasury Notes is only 2.78%.

Remember:

Take extra care when dealing with certain bond dealers and make sure that they are offering the appropriate bonds.  Some might influence you to buy questionable bonds that would just benefit their commission and not your portfolio.  These people may be bond-specific dealers and even financial advisors from investment firms.

Take note that not all dealers and financial advisors are well trained in dealing with special instruments like municipal bonds. It could be a major disadvantage for you to follow a wrong advice from anyone.  Whatever instruments you have in mind, it is always wise to do your own research first.  Find out everything you can about municipal bonds to see what type is really right for you.

Final Words

Municipal bonds are loaded with advantages for investors.

They will help you avoid or minimize taxes as you grow your portfolio.  Do your homework before you rush out into the municipal bond market and start scooping everything up. Remember that no investment instrument is perfect by itself.  Municipal bonds may not be the best choice to diversify your portfolio.  This is particularly true if you belong to the low tax bracket.

However, if you are in the high tax bracket, municipal bonds may work for you.  They are conservative investments that provide tax-exempt returns.  It is an attractive solution to diversify your investment portfolio.

Do you invest in municipal bonds?  What is your experience like in dealing with municipal bonds and with the municipal bond market?

Play