Municipal Bonds Basics: Learn What They Are and How They Work
Municipal bonds are loans investors make to local governments. Although there are other forms of investment products issued through government entities, municipal bonds, or “munis,” offer some specific perks that appeal to certain investors. Read on to find out if municipal bonds are right for you.
What Are Municipal Bonds?
Municipal bonds are popular debt security investment tools issued by the government. When state and local governments, such as cities and counties, need to finance projects, they might raise the necessary money by selling bonds. Bonds typically pay for capital investments like building roads, bridges, airports, water treatment facilities and hospitals to benefit the public. By funding projects through municipal bonds, agencies can distribute the cost of the projects across several generations.
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Important Bond Terms
Like with other investment products, there are key terms investors should know to help them make decisions to buy or sell bonds. When you’re considering investing in municipal bonds, take the time to learn and understand these terms:
- Coupon refers to the bond’s interest rate.
- Face value is the amount of money the bond is worth when issued.
- Par value is another name for face value.
- Price refers to the amount of money it costs to buy a particular bond in the secondary market.
- Yield refers to the amount of money an investor can make on a bond.
Types of Municipal Bonds
Although there are many different types of municipal bonds, the two most common are general obligation bonds and revenue bonds. The primary difference between these two categories is the funding source used by the bond issuer to pay interest payments and the principal owed to the bondholder.
General obligation bonds are backed by the credit of the issuing jurisdiction rather than the revenue from a specific project. That means the government entity can pay interest payments and the principal from its budget. It can also subject the bondholder to added risk because the bondholder cannot be paid if the issuing agency doesn’t receive the revenue it expects.
Revenue bonds are supported by specific projects, such as toll bridges and highways. Money collected from tolls or subsidies from the federal government covers the cost of interest and principal payments to bondholders. Some revenue bonds are funded through taxes like property taxes and hotel occupancy taxes.
It’s not enough to know these basic differences. Bond issuers structure bonds to offer buyers certain benefits, risks and tax advantages, thus increasing their appeal. For this reason, buyers should view each bond and carefully investigate the ones they’re considering before they purchase them.
- Conduit bonds are a type of revenue bond. A third party, such as a nonprofit agency, agrees to take responsibility for paying the interest and principal.
- Insured bonds are backed by commercial insurance companies that agree to pay whatever is due to bondholders if the municipality defaults on the agreement.
- Market discount bonds are bonds sold in a secondary market at a price lower than face value.
- Municipal notes are short-term bonds that usually mature in one year or less. These bonds give government agencies access to money they need while they wait for revenue to build up.
- Original issue discount bonds are sold at a price less than their face value. Interest earned on these bonds is tax-exempt and not subject to capital gains taxes.
- Pre-refunded bonds have the backing of Treasury securities kept in an escrow account that generate the cash needed to pay the interest and principal of the bond.
- Taxable municipal bonds are issued for nonsubsidized federal government projects, like building a stadium, that don’t quite benefit the public as much as a bridge might, for example.
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How Do Municipal Bonds Work?
Although people invest and make money buying/selling stocks and bonds, there are important distinctions between these investment vehicles. Stockholders have ownership in a company, whereas bondholders don’t have any ownership rights over the project they’re funding. Rather, the bond is essentially a loan given to the government entity.
In exchange for the loan, the bondholder earns interest until the municipal bond matures. The maturity date refers to the date the bond issuer must repay the principal. Depending on how the bond is structured, this can be anywhere from a few months to a few decades after issuance. Most bonds pay interest to investors semiannually until the maturity date.
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Where To Buy Municipal Bonds
Investors interested in municipal bonds might wonder where to buy them. You can go through a broker who can also review your financial goals and discuss an investment strategy with you. Other options include trading online through a self-managed account or picking up shares of a municipal bond mutual fund or municipal bond exchange-traded fund.
Are Municipal Bonds a Good Investment?
In general, the risk involved in municipal bonds is low. But bonds are not completely risk-free. For instance, there is a risk that the issuer won’t be able to meet the financial obligation once the maturity date is reached. This means the bondholder can lose money on the investment. Alternatively, the bond issuer might decide to call the bond before the maturity date. In this case, the bondholder receives the principal paid but loses out on the opportunity to earn interest.
Other risks occur as a result of economic changes — especially fluctuations in interest rates. Bond prices decrease when interest rates decline, which makes them less appealing. Many investors find that bonds are not highly liquid because they are not traded regularly. Finding a buyer for a bond in a secondary market can be a challenge. When forced to sell their bonds before they reach the maturity date, investors stand to lose money on the investment.
Investing in municipal bonds is just one way to invest your money, and it’s not the right decision for every investor. When considering picking up bonds as part of your investment strategy, speak to an advisor about your options before making a final decision.
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This article has been updated with additional reporting since its original publication.