Municipal Bonds

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Municipal Bonds

Municipal bonds (nicknamed munis) are bonds issued by states, cities, counties, and other municipalities. They are used to raise money to finance operations or to pay for projects: hospitals, schools, power plants, office buildings, and airports, among others.

Basic facts about munis

Individual investors purchase the majority of municipal bonds. These bonds are usually issued in $5,000 face-value denominations or multiples of $5,000. They mature in anywhere from one to fifty years. Like other bonds, they may also be bought at a discount. For example, an investor may buy a $5,000 bond for only $4,000. At maturity, he or she will receive the $5,000 face value.

After they have been issued, they can be sold to other investors on the secondary market over the counter.

The two main types

The two main forms of municipal bonds are general obligation and revenue bonds. These two types are distinguished according to whether they are secured or unsecured.

General obligation bonds

General obligation bonds (GO bonds) are unsecured municipal bonds backed by the credit and taxing power of the issuing jurisdiction rather that the revenue of a specific product. They have maturities ranging from 1 to 30 years. The creditworthiness of the issuing city or state is the only "security" they provide. GO bonds finance projects that do not produce revenue. If it is unable to, it may turn to taxation to guarantee interest and principal payments.

Revenue bonds

Revenue bonds are secured by the revenues generated by the projects they fund. Such revenues include tolls, fees, and lease payments. For example, a city may issue revenue bonds to pay for a new stadium. It will pay bondholders their interest and principal from the stadium’s revenues. Default will occur if revenues are not high enough to pay bondholders. In that case, payments to bondholders may be deferred.

Revenue bonds may involve higher risk than GO bonds. This is because of the possibility that the projects financed may not bring in enough revenue to pay bondholders. However, these bonds also may pay higher interest rates.

Tax advantages make them popular

Most municipal bonds are free of federal income taxes on interest distributions. Also, most are free of state and local taxes in the state in which they are issued. These features can make them popular among small investors. However, capital gains are not exempt from taxes. Gains on municipals purchased with market discount can be considered interest and not capital gains.

The relative security and tax savings of municipal bonds make them a popular addition to the portfolios of many investors.