What is a Municipal Bond?

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An Introduction to Small Scale Fixed Income Investment

A municipal bond is a bond issued by a city or another local government agency.

Municipal bonds can be issued by a number of different government entities, sometimes including cities, counties, school boards and publicly owned airports and seaports or any other government agency below the state or provincial level. The income received by the holders of municipal bonds is generally exempt from income tax. However, some municipal bonds may be subject to income tax depending on the circumstances under which the bond was issued and regional by-laws.

The Purpose of Municipal Bonds

Municipal bonds are sometimes issued by counties, special purpose districts and other agencies of local government to raise funds for public projects. There are a number of methods for the issuing and tracking of debt. These methods are governed by a complicated set of laws and regulations that varies by country or region. Municipal bonds can bear interest at both fixed and variable rates. These rates can be subject to a cap known as the maximum legal limit. Municipal bond measures proposed during a county election must include a tax rate statement so that voters can examine what the bond will cost and how it will be paid for.

The issuers of municipal bonds usually use the proceeds to raise capital for projects that they can not pay for right away. Tax laws generally require the issuer to spend all of the funds generated by the sale of the bond within three to five years.

Because most municipal bonds are exempt from taxes, investors are usually willing to accept lower interest payments on the grounds of less risk. This makes issuing municipal bonds an attractive option for municipal entities because the borrowing rate on the open market is often lower than with other forms of finance.

Prospective investors can purchase municipal bonds either directly from the issuer, on the primary market, or from other investors, on the secondary market. In exchange for up front capital, the bond holder receives payments over a preset period of time from the issuer, in the form of interest. The initial investment is returned, along with the principal when the bond matures.

The Risk and Taxability of Municipal Bonds

Repayment schedules for municipal bonds can differ, depending on the type of bond. Municipal bonds usually pay interest on a semi-annual basis until they reach maturity. Long term municipal bonds return interest in the form of amortized annual payments. Some types of bonds, known as capital appreciation bonds, accrue interest until they reach maturity and the principal becomes due.

One of the primary reasons that municipal bonds are considered separately than other types of bonds is because the interest generated by municipal bonds is generally tax free, depending on where the bond is issued.

The taxability of municipal bonds is also affected by the type of project that the revenue generated is intended to fund. Interest earnings from bonds meant to fund public works projects is generally exempt from taxes. However, municipal bonds issued to fund private projects may be subject to income tax.

The laws governing the taxability of municipal bonds are complex. However, bonds are usually certified by a lawyer as tax-exempt before they can be sold on the market. Purchasers of municipal bonds must be made aware of where or not a municipal bond is exempt from taxation.

Repayment of Municipal Bonds

The risk, or security, of a municipal bond is measured in how likely the issuer is to make all of the payments stipulated in the agreement, with the investor. Different types of bonds can be repaid in different ways depending on the promises made in the bond documents.

The probability of repayment is determined by an independent reviewer, or “rating agency.” There are three major rating agencies in the United States, Standard and Poor, Moody’s and Fitch. These agencies can be hired by bond issuers to assign a bond rating. This information is valuable to both issuers and buyers, as it indicates how well a bond will sell on the primary market.

This information is key to determining the security of promised repayments. Other pertinent information and official statements are usually available at no charge from government organizations, such as the Municipal Market Access system, which is operated by the Municipal Securities Rule-making Board. In recent years, the issuers of municipal bonds have been required to provide continuing disclosure to the market.

Municipal Bonds and the Sub-prime Mortgage Crisis

The municipal bond market was adversely affected by the American sub-prime mortgage crisis in 2008. During the resulting economic instability, many insurance companies that insure municipal bonds incurred significant financial loses, causing the price of municipal bonds to fall.

Sources

Municipal Bond Tax Regulations

Securities Industry and Financial Markets Association

About Municipal Bonds

Municipal Finance Journal

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