Municipal Bonds and How They Work

Municipal bonds are loans that investors make to local governments. They are issued by cities, states, counties, or other local governments. For that reason, the interest they pay on the bonds is tax-free for residents of that state. In 2020, the municipal bond market was worth $3.9 trillion.

Municipal bonds are securities. The original owner may sell them to other investors on the secondary market. That allows the bond's price to change. Holding the bond until maturity, your investment's rate of return will not be affected by market changes.

Three Types of Bonds

There are three types of municipal bonds. One of the most common types is general obligation bonds. The borrower generally repays them by using tax revenue, and they are not backed by a specific asset or project that will produce revenue.

Revenue bonds are the other most common type of municipal bonds. The municipality repays those with proceeds from a specific source. These bonds pay for revenue-generating projects. That includes toll highways, sports arenas, or city-sponsored developments. If the revenue sources dry up, the municipality doesn't have to pay.

The third type of bonds is made on behalf of private groups with a public purpose. They include non-profit colleges and hospitals. The municipality just arranges the sale of the bonds, is generally not liable for these debts if the private entity doesn't pay. 

How They Work

Municipal bonds pay interest to investors, usually twice a year. Bond issuers repay the principal on the bond's maturity date. That's one to three years for short-term bonds and 10 years or more for long-term bonds.

Municipal bonds are generally not subject to federal taxes on interest, and they are often exempt from state and local taxes. As a result, they have slightly lower interest rates than taxable bonds. You can buy municipal bonds directly from a registered municipal bond seller. You can also own them indirectly through a municipal bond fund.

In the past, very few cities defaulted. Municipal bonds are considered very low risk. Those that sell before the bond matures find that the price of the bond itself changes based on supply and demand in the open market.

Rates

Like any bond, municipal bond rates depend on three factors. Most bond rates follow the equivalent Treasury bond yield. These are risk-free bonds issued by the federal government. Since munis have a bit more risk, they will pay slightly higher rates than federal bonds.

It also depends on the municipality's credit rating. The highest is AAA. Since they are also the safest, they pay the lowest rates. Lower-rated bonds pay a higher rate to compensate investors for the greater risk of default.

The length of the bond will change the yield. Bonds with longer maturities, such as 10 to 30 years, will pay more than short-term bonds of less than 10 years. Investors rightfully expect a higher return to have their money tied up for a longer period.

You can get a ballpark idea of how current municipal bond rates compare through any bond broker. It's best to consult with your financial planner to find out which bond fits in best with your financial goals.

How to Buy Municipal Bonds

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

You can also research municipal bonds yourself at the Electronic Municipal Market Access website. It provides each bond's type, yield, and maturity. It also gives you the bond's credit quality, risk factors, and audited financial statements.

You just click on the state to start searching for bonds in your area. The site also provides statistics and the ability to compare prices on bonds. If you want to buy lots of municipal bonds yourself, this is the place to go.

Four Looming Threats

In 2014, former Federal Reserve Chairman Paul Volcker co-authored a three-year study with the boring title, "Final Report of the State Budget Crisis Task Force." Its findings were anything but boring. The team uncovered structural flaws in state and city financing that are worsening. That represents a future threat to all municipal bondholders. At its worst, it could trigger another financial crisis.

The four threats to the municipal bond market are:

1. Contributions to employee pension funds aren't enough to cover future guaranteed payouts to retirees. Cities have three poor choices. They must either raise taxes, reduce spending on other services, or cut benefits. 
2. The largest expenditure for state budgets is Medicaid. These health costs are rising, which could cut into state revenue-sharing with cities.  
3. Cities and states are issuing bonds to cover current operating costs.
4. They are selling off assets to pay operating expenses.

As a result, many cities don't have the funds to invest in new infrastructure. That includes roads, bridges, and buildings. It also includes education and other services. 

Example: How Detroit's Bankruptcy Changed the Game

On July 18, 2013, the city of Detroit filed for Chapter 9 bankruptcy on $18.5 billion in debt. It was the largest American city to take this desperate action. Detroit used the bankruptcy to default on its general obligation bonds. It said it no longer had the income to pay for the bonds.

Creditors and insurers absorbed $7 billion in losses. They received between 14 and 75 cents on the dollar, depending on the type of bond. Pension funds agreed to a minimum 6.75% return. That was lower than what they had before, but still a high rate of return compared to other risk-free investments.  That was in return for a less than 5% cut to pension payments, an end to cost-of-living increases, and higher health care contributions. Detroit promised to spend $1.5 billion more on services.

The ruling has a long-term impact on the U.S. economy by setting national precedents. The central issue at stake was who will pay the price. Will it be bondholders or city workers, whether currently employed or retired? Or will it be the residents?