What are Municipal Bonds and How Do They Work?

A municipal bond (also called a “muni”) is a type of debt security issued by a city, county, state, or other government entity to fund expensive and long-lived capital projects such as highway, school, airport, and bridge construction.

According to the Tax Policy Center, as of 2019, state and local governments had almost $4 trillion dollars in debt outstanding in the form of municipal bonds: 98% of which was long-term (often ten years or more) or worth a maturity of 13 months or longer. Even more interesting is that 46% of households are estimated to hold most of these bonds.

Because municipal bonds are such a popular consumer investment, we’ll provide details on how they work and cover their benefits and risks to help you decide if they are right for you.

Municipal bonds, further explained

Municipal bonds generally fall into two categories: general obligation bonds (GOs) and revenue bonds.

States, cities, or counties issue general obligation bonds, which reflect a lower risk than other types because they are backed by dedicated taxes on property or general funds (often referred to as “backed by the full faith and credit” of the issuer, which means the government is authorized to tax residents for bondholder repayment purposes).

These bond types are further divided into two categories: unlimited tax and limited tax obligation bonds. Unlimited tax bonds are backed by the power of the issuer in that various tax revenue sources can be used to repay the bonds. Limited tax obligation bonds are narrower in taxing power, as municipalities may pass a specific tax (e.g., a sales tax increase) to repay the debt.

Alternatively, revenue bonds are tied to income generated from a specific project or source such as money produced via tolls or hotel occupancy taxes. Given the gamble that these projects or taxes won’t produce enough money to pay investors back, revenue bonds carry more risk than general obligation bonds.

Water, sewer, and utilities revenue bonds are typically viewed as less risky within the revenue bond category as they are essential services and therefore more likely to meet their debt obligations. While there are many variables to consider, education, hospital, and healthcare are often considered the riskiest investments within this category; according to Schwab, nearly 30% of all municipal bonds that default are in the hospital and retirement sector.

When a municipality is a conduit issuer of revenue bonds, it means a third party (typically a private nonprofit 501(c)(3) entity) is responsible for interest and principal payments: thus adding more risk as the issuing government agency isn’t the guarantor.

How municipal bonds work

To illustrate, let’s assume a state government wants to expand one of its airports at an estimated cost of $300 million with a 10-year completion timeframe. They decide to issue bonds to help fund the project since budget allocations fall short. Soon thereafter, they seek taxpayer approval (typically via a ballot) for the additional proposed spending.

The bonds are later issued with a maturity date of ten years, meaning the date when the bond is due or when investors recoup their original investment or principal. They also set a par (or denomination) value of $5,000 (typical for municipal bonds), which is the face value or value at maturity. The coupon rate—the amount of interest paid to the investor annually—is set at 3% in this example. Therefore, if you retain this bond, you’d earn $150 in annual interest until ten years later: at which point you’d receive your principal investment of $5,000.

Municipal bond advantages

The biggest benefit of investing in a municipal bond is the associated tax advantage. Generally speaking, the interest you earn on a municipal bond is exempt from federal taxes; and, if you live in the state where the bond was issued, you are sometimes also exempt from state taxes.

Municipal bonds also have a very low risk of default, especially when compared to their corporate counterparts. According to Moody’s—a credit ratings business—only .08% of municipal bonds defaulted between 1970 and 2019 compared to 6.7% for corporate bonds during that same period: although we’re likely due for a slight increase given the COVID-19 pandemic. What’s more, municipal bonds rated by a nationally recognized statistical rating organization (e.g., Moody’s, Fitch, or S&P Global) and specifically general obligation bonds have historically experienced even lower default rates.

Municipal bonds can also provide investors with a steady, predictable rate of return that is less volatile than other investments (e.g., stocks) and typically offer a higher return than a certificate of deposit. They can also help with portfolio diversification, especially if you retain higher-risk investments.

Municipal bond risks

The bond issuer sometimes has an option to redeem the bond prior to the maturity date through what’s known as a “call provision,” which many municipal bonds carry. In this scenario, the bondholder would receive all interest payments due up until that time as well as their invested principal. Generally speaking, a call provision is often executed when interest rates drop since the municipality can thus reissue bonds at a lower interest rate.

Municipal bonds also carry interest rate risk, especially when longer maturities are involved as this makes them more susceptible to rate fluctuations than bonds with short-term maturities. As interest rates rise, existing bond market prices decline. Consider our earlier example whereby you purchased a bond for $5,000 with a 3% coupon rate that pays you $150 in annual interest. If interest rates rise to 5% and new bonds are issued, investors earn $250 in annual interest payments for their $5,000 investment. If you decide to sell your bond for a new one, you’d need to do so at a discounted price that gives the new owner a similar 5% yield. Alternatively, you can also sell your bond when rates fall—assuming a call provision isn’t enacted.

While these risks are much lower compared to corporate bonds, a default is also possible: meaning you won’t recoup your investment. This is especially true when the municipality is a conduit issuer of the bonds or with respect to non-recourse bonds, wherein revenue-backed bonds aren’t obligated to pay back the bondholder if the intended revenue stream dries up.

Because municipal bonds tend to pay lower interest rates than other types of bonds, they can also summon inflation risks—whereby the fixed rate of interest you receive falls below the cost of inflation, thus reducing your purchasing power.

In sum: final thoughts on municipal bonds

As with any investment, potential risks and rewards accompany municipal bond investments. Thus, it is often best to consider this option when looking to diversify your portfolio with a low-risk, tax-exempt opportunity.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.