Posted by Tim Thompson CPA PLLC

Municipal Bonds and How They Work

Municipal Bonds and How They Work

What is Municipal Bond

A municipal bond is a debt issued by a municipality, state, or a country to finance capital expenditures, including the construction of schools, highways, or bridges. They can be viewed as loans that investors make to municipalities. Municipal bonds are exempt from most state, federal, and municipal taxes, making them particularly attractive to people with high-income taxes. Municipal bonds, also called "munis" or "muni bonds," are a type of municipal warrants, a category that also includes tickets, guarantees, participation certificates, and other similar obligations.

Key Notes:

    •    Municipal bonds can be viewed as loans made by investors to local governments.

    •    These bonds are issued by cities, states, and even countries.

    •    Interest paid on municipal bonds is generally tax-exempt, making it an attractive investment option for people with high tax rates.

Understanding Municipal Bonds

A municipal bond is a debt issued by a non-profit organization, a private sector company, or another public entity that uses the loan for public projects, such as the construction of hospitals, schools, and highways.

Types Of Municipal Bonds

A municipal bond is classified according to the source of the main interest and payments. Security can be structured in different ways, offering various tax advantages, risks, and treatments. Income generated by a municipal bond is taxable. For example, a municipality can issue a guarantee without reservation of federal tax exemption, which generates generated revenues subject to federal taxes.

A general obligation bond is issued by public bodies and is not supported by the income from the individual project, such as a toll road. Property taxes guarantee individual GO bonds; others are paid with general funds.

An income bond guarantees payments and interest from the principal through the issuer or fuel, sales, hotel rental, or other taxes. When a municipality is a conductor, a third party takes care of the interest and capital payments.

Risks Of Municipal Bonds

The risk of insolvency is low for municipal bonds compared to corporate bonds. However, income bonds are more vulnerable to changes in consumer taste or general economic decline than general obligation bonds. For example, sewage treatment, water supply, or other essential service facilities have more reliable incomes than profitable park shelters.

To guarantee fixed income, the market price of a municipal bond has fluctuated with changes in dividend rates: when interest rates rise, bond prices fall; when interest rates fall, bond prices rise. Also, a long term guarantee is more sensitive to changes in interest rates than a shorter-term guarantee, resulting in even more significant variations in the income of municipal bond investors. In addition, most municipal bonds are unused; an investor who needs immediate cash must sell other securities.

Many municipal bonds have purchase agreements that allow the issuer to redeem the bonds before the maturity date. Usually, an issuer requests a bond when interest rates fall and issues municipal bonds at a lower interest rate. When a bond is requested, investors lose their interest payments and risk being reinvested in a weaker yield bond. 

How Municipal Bonds Works

Municipal bonds pay dividends to investors twice a year. Security issuers repay the principal on the expiration date of the bond. It is one or three years for short-term bonds and ten years or more for long-term bonds. Municipal bonds work great for investors who need a tax-free income stream.

They are investors in a higher tax category. As a result, their interest rates are slightly lower than those of tax liabilities. Municipal bonds can be purchased directly from a registered municipal bond seller. You can also hold them indirectly via a municipal bond fund.

Municipal bonds are considered a slight risk; hence, in the past, only a few cities defaulted. Most individual municipal bondholders do not sell during the term of the loan. But those who believe that the price of bonds changes according to supply and demand on the free market.

Rates

As with any obligation, municipal taxes depend on three factors. Most bond rates follow a yield equivalent to treasury bills. These are no-risk bonds issued by the federal government. Because bonds present a slightly higher risk, they will pay slightly higher commissions than federal bonds.

It also depends on the rating of the municipality. Because they are also the safest, they pay the lowest rates. Low-rated bonds pay a higher commission to compensate investors for the increased risk of default.

The duration of the bonus will affect your performance. Securities with maturities more significant than 10 to 30 years will pay more than short-term securities for less than ten years. Investors are legitimately expecting higher returns for a more extended period.

You can get a general idea of the composition of the current municipal bond rate with Bloomberg or any other bond broker. It is best to consult your financial planner to find out which link best fits your financial goals.

How To Buy Municipal Bonds

Most people buy municipal bonds directly through the financial advisor, the bank, or even the municipality. Besides, many people benefit from municipal bonds through a bond fund.

You can also search for municipal bonds on the electronic market access site. Indicate the type, yield, and maturity of each guarantee. It also guarantees credit quality, risk factors, and financial statements certified for security.

Four Future Threats

In 2014, former chairman of the Federal Reserve, Paul Volcker, co-authored a three-year study titled "Final Report of the State Budget Crisis Task Force." His discoveries were far from boring. The team found structural flaws in worsening public and municipal funding. This poses a future threat to all holders of municipal bonds. In the worst case, this could trigger a new financial crisis.

The threats to the municipal bond market are:

    •    Contributions to employee pension funds are not sufficient to cover future guaranteed payments to retirees. 

    •    The biggest expense for state budgets is Medicaid. These health costs are increasing, which could reduce the distribution of state revenues in cities.

    •    Cities and states publish programs to cover current operating expenses.

    •    Sell goods to pay for operating expenses.

As a result, many cities do not have the resources to invest in new infrastructure. This includes buildings, roads, and bridges. This also includes education and other services.

Tim Thompson CPA PLLC
Contact This Member